An Introduction to
Muhammad Taqi Usmani
an
INTRODUCTION
to
ISLAMIC FINANCE
Mufti Muhammad Taqi Usmani
Contents
Foreword 6
Some Preliminary Points 9
Belief in Divine Guidance 9
The Basic Difference between Capitalist and Islamic
Economy 10
Asset-backed Financing 12
Capital and Entrepreneur 14
Present Practices of Islamic Banks 15
Musharakah 17
The Concept of Musharakah 19
The Basic Rules of Musharakah 23
Distribution of Profit 23
Ratio of Profit 24
Sharing of Loss 24
The Nature of the Capital 25
Management of Musharakah 28
Termination of Musharakah 28
Termination of Musharakah without Closing the Business 29
Mudarabah 31
Business of the Mudarabah 32
Distribution of the Profit 33
Termination of Mudarabah 34
Combination of Musharakah and Mudarabah 35
CONTENTS
Musharakah & Mudarabah as Modes of Financing 37
Project Financing 38
Securitization of Musharakah 39
Financing of a Single Transaction 42
Financing of the Working Capital 43
Some Objections on Musharakah Financing 52
Risk of Loss 52
Dishonesty 54
Secrecy of the Business 55
Clients' Unwillingness to Share Profits 56
Diminishing Musharakah 57
House Financing on the Basis of Diminishing Musharakah 59
Diminishing Musharakah for Carrying Business of Services 63
Diminishing Musharakah in Trade 63
Murabahah 65
Introduction 65
Some Basic Rules of Sale 66
Bai' Mu'ajjal (Sale on Deferred Payment Basis) 70
Murabahah 71
Murabahah as a Mode of Financing 72
Basic Features of Murabahah Financing 73
Some Issues Involved in Murabahah 76
Different Pricing for Cash and Credit Sales 16
The Use of Interest-Rate as Benchmark 81
Promise to Purchase 83
Securities against Murabahah Price 88
Guaranteeing the Murabahah 90
Penalty of Default 9 1
No Roll Over in Murabahah 98
Rebate on Earlier Payment 99
Calculation of Cost in Murabahah 100
Subject Matter of Murabahah 102
Rescheduling of Payments in Murabahah 103
Securitization of Murabahah 103
Some Basic Mistakes in Murabahah Financing 104
CONTENTS
Conclusions 106
Ijarah 109
Basic Rules of Leasing hi
Lease as a Mode of Financing 113
1. The Commencement of Lease 114
2. Different Relations of the Parties 115
3. Expenses Consequent to Ownership 116
4. Liability of the Parties in Case of Loss to the Asset 117
5. Variable Rentals in Long Term Leases 117
6. Penalty for Late Payment of Rent 120
7. Termination of Lease 120
8. Insurance of the Assets 121
9. The Residual Value of the Leased Asset 121
10. Sub-Lease 123
1 1 . Assigning of the Lease 1 24
Securitization of Ijarah 125
Head-Lease 126
Salam and Istisna' 128
Salam 128
Conditions of Salam 129
Salam as a Mode of Financing 133
Some Rules of Parallel Salam 134
Istisna' 135
Difference Between Istisna' and Salam 136
Difference Between Istisna' and Ijarah 136
Time of Delivery 137
Istisna' as a Mode of Financing 138
Islamic Investment Funds 140
Equity Fund 141
Conditions for Investment in Shares 143
Ijarah Fund 147
CONTENTS
Commodity Fund 148
Murabahah Fund 149
Bai'-Al-Dain 150
Mixed Fund 151
The Principle of Limited Liability 152
Waqf 154
Baitul-Mal 155
Joint Stock 156
Inheritance under Debt 157
The Limited Liability of the Master of a Slave 158
The Performance of the Islamic Banks — A Realistic
Evaluation 161
Foreword
Over the last few decades, the Muslims have been trying to
restructure their lives on the basis of Islamic principles. They
strongly feel that the political and economic dominance of the
West, during past centuries, has deprived them of the divine
guidance, especially in the socio-economic fields. Therefore, after
acquiring political freedom, the masses are striving for the revival of
their Islamic identity to organise their collective life in accordance
with the Islamic teachings.
In the economic field, it was the biggest challenge for such
Muslims to reform their financial institutions to bring them in
harmony with the dictates of Shari'ah. In an environment where the
entire financial system was based on interest, it was a formidable
task to structure the financial institutions on an interest free basis.
The people not conversant with the principles of Shari'ah and
its economic philosophy sometimes believe that abolishing interest
from the banks and financial institutions would make them
charitable, rather than commercial, concerns which offer financial
services without a return.
Obviously, this is totally a wrong assumption. According to
Shari'ah, interest free loans are meant for cooperative and charitable
activities, and not normally for commercial transactions, except in a
very limited range. So far as commercial financing is concerned, the
Islamic Shari'ah has a different set-up for that purpose. The
FOREWORD
principle is that the person extending money to another person
must decide whether he wishes to help the opposite party or he
wants to share his profits. If he wants to help the borrower, he must
rescind from any claim to any additional amount. His principal will
be secured and guaranteed, but no return over and above the
principal amount is legitimate. But if he is advancing money to
share the profits earned by the other party, he can claim a stipulated
proportion of profit actually earned by him, and must share his loss
also, if he suffers a loss.
It is thus obvious that exclusion of interest from financial
activities does not necessarily mean that the financier cannot earn a
profit. If financing is meant for a commercial purpose, it can be
based on the concept of profit and loss sharing, for which
musharakah and mudarabah have been designed since the very
inception of the Islamic commercial law.
There are, however, some sectors where financing on the basis
of musharakah or mudarabah is not workable or feasible for one
reason or another. For such sectors the contemporary scholars have
suggested some other instruments which can be used for the
purpose of financing, like murabahah, ijarah, salam or istisna.
Since last two decades, these modes of financing are being used
by the Islamic banks and financial institutions. But all these
instruments are not the substitutes of interest in the strict sense, and
it will be wrong to presume that they may be used exactly in the
same fashion as interest is used. They have their own set of
principles, philosophy and conditions without which it is not
allowed in Shari'ah to use them as modes of financing. Therefore
the ignorance of their basic concept and relevant details may lead to
confusing the Islamic financing with the conventional system based
on interest.
The present book is a revised collection of my different articles
that aimed at providing basic information about the principles and
precepts of Islamic finance, with special reference to the modes of
financing used by the Islamic banks and non-banking financial
institutions. I have tried to explain the basic concept underlying
these instruments, the necessary requirements for their acceptability
from the Shari'ah standpoint, and the correct method of their
application. I have also dealt with the practical issues involved in the
7
AN INTRODUCTION TO ISLAMIC FINANCE
application of these instruments and their possible solutions in the
light of Shari'ah.
In my capacity as chairman / member of the Shari'ah
Supervisory Boards of a number of Islamic banks in different parts
of the world, I came across the points of weakness in their
operations caused mainly by the lack of clear perception of the
relevant rules and principles of Shari'ah. This experience
emphasized the need for the present book in which I have tried to
discuss the relevant subject in a simple way which may be easily
understood by a common reader who had no opportunities to study
the Islamic financial principles in depth.
This humble effort, I hope, will facilitate to understand the
basic principles of Islamic finance and the main points of difference
between conventional and Islamic banking. May Allah Ta'ala accept
this humble effort, honour it with His pleasure and make it
beneficial for the readers.
I
Muhammad Taqi Usmani
Karachi
04.03.1419 A.H.
29.06.1998 A.D.
Some Preliminary
Points
Before the details of Islamic modes of financing are discussed, it
seems necessary to explain some points concerning the basic
principles that govern the whole economic set-up in an Islamic way
of life.
Belief in Divine Guidance
The foremost belief around which all the Islamic concepts revolve is
that the whole universe is created and controlled by One, the only
One God. He has created man and appointed him as His vicegerent
on the earth to fulfil certain objectives through obeying His
commands. These commands are not restricted to some modes of
worship or so-called religious rituals. They, on the contrary, cover a
substantial area of almost every aspect of our life. These commands
are neither so exhaustive that straiten the human activities within a
narrow circle, leaving no role for human intellect to play, nor are
they so little or ambiguous that they leave every sphere of life at the
mercy of human perception and desire. Far from these two
extremes, Islam has a balanced approach to govern the human life.
On the one hand, it has left a very wide area of human activities to
man's own rational judgment where he can take decisions on the
basis of his reason, assessment of facts and expedience. On the other
hand, Islam has subjected human activities to a set of principles
which have eternal application and cannot be violated on superficial
grounds of expediency based on human assessment.
AN INTRODUCTION TO ISLAMIC FINANCE
The fact behind this scheme is that human reason, despite its
vast capabilities, cannot claim to have unlimited power to reach the
truth. After all, it has some limits beyond which it either cannot
properly work or may fall prey to errors. There are numerous
domains of human life where 'reason' is often confused with
'desires' and where unhealthy instincts, under the disguise of
rational arguments, misguide humanity to wrong and destructive
decisions. All those theories of the past which are held today to be
fallacious, claimed, in their respective times, to be 'rational' but it
was after centuries that their fallacy was discovered and their
absurdity was universally proved.
It is thus evident that the sphere of work delegated to human
'reason' by its Creator is not unlimited. There are areas in which
human reason cannot give proper guidance or, at least, is susceptible
to errors. It is these areas in which Allah Almighty, the Creator of
the universe, has provided guidance through His revelations sent
down to His prophets. On the basis of this approach it is the firm
belief of every Muslim that the commands given by the divine
revelations through the last Messenger s|§ are to be followed in
letter and spirit and cannot be violated or ignored on the basis of
one's rational arguments or his inner desires. Therefore, all the
human activities must always be subject to these commands and
must work within the limits prescribed by them. Unlike other
religions, Islam is not confined to some moral teachings, some
rituals or some modes of worship. It rather contains guidance in
every sphere of life including socio-economic fields. The obedience
from servants of Allah is required not only in worship, but also in
their economic activities, even though it is at the price of some
apparent benefits, because these apparent benefits may go against
the collective interest of the society.
The Basic Difference between Capitalist and Islamic
Economy
Islam does not deny the market forces and market economy. Even
the profit motive is acceptable to a reasonable extent. Private
ownership is not totally negated. Yet, the basic difference between
capitalist and Islamic economy is that in secular capitalism, the
profit motive or private ownership are given unbridled power to
10
SOME PRELIMINARY POINTS
make economic decisions. Their liberty is not controlled by any
divine injunctions. If there are some restrictions, they are imposed
by human beings and are always subject to change through
democratic legislation, which accepts no authority of any super-
human power. This attitude has allowed a number of practices
which cause imbalances in the society. Interest, gambling,
speculative transactions tend to concentrate wealth in the hands of
the few. Unhealthy human instincts are exploited to make money
through immoral and injurious products. Unbridled profit making
creates monopolies which paralyse the market forces or, at least,
hinder their natural operation. Thus the capitalist economy which
claims to be based on market forces, practically stops the natural
process of supply and demand, because these forces can properly
work only in an atmosphere of free competition, and not in
monopolies. It is sometimes appreciated in a secular capitalist
economy that a certain economic activity is not in the interest of the
society, yet, it is allowed to be continued because it goes against the
interest of some influential circles who dominate the legislature on
the strength of their majority. Since every authority beyond the
democratic rule is totally denied and 'trust in God' (which is
affirmed at the face of every U.S. dollar) has been practically
expelled from the socio-economic domain, no divine guidance is
recognized to control the economic activities.
The evils emanating from this attitude can never be curbed
unless humanity submits to the divine authority and obeys its
commands by accepting them as absolute truth and super-human
injunctions which should be followed in any case and at any price.
This is exactly what Islam does. After recognizing private
ownership, profit motive and market forces, Islam has put certain
divine restrictions on the economic activities. These restrictions
being imposed by Allah Almighty, Whose knowledge has no limits,
cannot be removed by any human authority. The prohibition of
rib a (usury or interest), gambling, hoarding, dealing in unlawful
goods or services, short sales and speculative transactions are some
examples of these divine restrictions. All these prohibitions
combined together have a cumulative effect of maintaining balance,
distributive justice and equality of opportunities.
11
AN INTRODUCTION TO ISLAMIC FINANCE
Asset-backed Financing
One of the most important characteristics of Islamic financing is
that it is an asset-backed financing. The conventional / capitalist
concept of financing is that the banks and financial institutions deal
in money and monetary papers only. That is why they are
forbidden, in most countries, from trading in goods and making
inventories. Islam, on the other hand, does not recognize money as
a subject-matter of trade, except in some special cases. Money has
no intrinsic utility; it is only a medium of exchange; Each unit of
money is 100% equal to another unit of the same denomination,
therefore, there is no room for making profit through the exchange
of these units inter se. Profit is generated when something having
intrinsic utility is sold for money or when different currencies are
exchanged, one for another. The profit earned through dealing in
money (of the same currency) or the papers representing them is
interest, hence prohibited. Therefore, unlike conventional financial
institutions, financing in Islam is always based on illiquid assets
which creates real assets and inventories.
The real and ideal instruments of financing in Shari'ah are
musharakah and mudarabah. When a financier contributes money
on the basis of these two instruments it is bound to be converted
into the assets having intrinsic utility. Profits are generated through
the sale of these real assets.
Financing on the basis of salam and istisnd also creates real
assets. The financier in the case of salam receives real goods and can
make profit by selling them in the market. In the case of istisna,
financing is effected through manufacturing some real assets, as a
reward of which the financier earns profit.
Financial leases and murabahah, as will be seen later in the
relevant chapters, are not originally modes of financing. But, in
order to meet some needs they have been reshaped in a manner that
they can be used as modes of financing, subject to certain
conditions, in those sectors where musharakah, mudarabah, salam
or istisna' are not workable for some reasons. The instruments of
leasing and murabahah are sometimes criticized on the ground that
their net result is often the same as the net result of an interest-
based borrowing. This criticism is justified to some extent, and that
is why the Shari'ah supervisory Boards are unanimous on the point
12
SOME PRELIMINARY POINTS
that they are not ideal modes of financing and they should be used
only in cases of need with full observation of the conditions
prescribed by Shari'ah. Despite all this, the instruments of leasing
and murabahah, too, are fully backed by assets and financing
through these instruments is clearly distinguishable from the
interest-based financing on the following grounds.
1. In conventional financing, the financier gives money to his
client as an interest-bearing loan, after which he has no concern as
to how the money is used by the client. In the case of murabahah,
on the contrary, no money is advanced by the financier. Instead, the
financier himself purchases the commodity required by the client.
Since this transaction cannot be completed unless the client assures
the financier that he wishes to purchase a commodity, therefore,
murabahah is not possible at all, unless the financier creates
inventory. In this manner, financing is always backed by assets.
2. In the conventional financing system, loans may be advanced
for any profitable purpose. A gambling casino can borrow money
from a bank to develop its gambling business. A pornographic
magazine or a company making nude films are as good customers of
a conventional bank as a house-builder. Thus, conventional
financing is not bound by any divine or religious restrictions. But
the Islamic banks and financial institutions cannot remain
indifferent about the nature of the activity for which the facility is
required. They cannot effect murabahah for any purpose which is
either prohibited in Shari'ah or is harmful to the moral health of the
society.
3. It is one of the basic requirements for the validity of
murabahah that the commodity is purchased by the financier which
means that he assumes the risk of the commodity before selling it to
the customer. The profit claimed by the financier is the reward of
the risk he assumes. No such risk is assumed in an interest-based
loan.
4. In an interest bearing loan, the amount to be repaid by the
borrower keeps on increasing with the passage of time. In
murabahah, on the other hand, a selling price once agreed becomes
and remains fixed. As a result, even if the purchaser (client of the
Bank) does not pay on time, the seller (Bank) cannot ask for a
higher price, due to delay in settlement of dues. This is because in
Shari'ah, there is no concept of time due of money.
13
AN INTRODUCTION TO ISLAMIC FINANCE
5. In leasing too, financing is offered through providing an asset
having usufruct. The risk of the leased property is assumed by the
lessor / financier throughout the lease period in the sense that if the
leased asset is totally destroyed without any misuse or negligence on
the part of the lessee, it is the financier/lessor who will suffer the
loss.
It is evident from the above discussion that every financing in
an Islamic system creates real assets. This is true even in the case of
murabahah and leasing, despite the fact that they are not believed to
be ideal modes of financing and are often criticized for their being
close to the interest-based financing in their net results. It is known,
on the other hand, that interest-based financing does not necessarily
create real assets, therefore, the supply of money through the loans
advanced by the financial institutions does not normally match with
the real goods and services produced in the society, because the
loans create artificial money through which the amount of money
supply is increased, and sometimes multiplied without creating real
assets in the same quantity. This gap between the supply of money
and production of real assets creates or fuels inflation. Since
financing in an Islamic system is backed by assets, it is always
matched with corresponding goods and services.
Capital and Entrepreneur
According to the capitalist theory, capital and entrepreneur are two
separate factors of production. The former gets interest while the
latter is entitled to profit. Interest is a fixed return for providing
capital, while profit can be earned only when there is a surplus after
distributing the fixed return to land, labour and capital (in the form
of rent, wages and interest) .
Islam, on the contrary, does not recognize capital and
entrepreneur as two separate factors of production. Every person
who contributes capital (in the form of money) to a commercial
enterprise assumes the risk of loss and therefore is entitled to a
proportionate share in the actual profit. In this manner 'capital' has
an intrinsic element of 'entrepreneurship', so far as the risk of the
business is concerned. Therefore, instead of a fixed return as
interest, it derives profit. The more the profit of the business, the
higher the return on capital. In this way the profits generated by the
14
SOME PRELIMINARY POINTS
commercial activities in the society are equitably distributed to all
those persons who have contributed capital to the enterprise,
however little it may be. Since in the context of the modern
practice, it is the banks and financial institutions who provide
capital to the commercial activities, out of the deposits made with
them, the flow of the actual profits earned by the society may be
directed towards the depositors in equitable proportions which may
distribute wealth in a wider circle and may hamper concentration of
wealth in the hands of the few.
Present Practices of Islamic Banks
It is sometimes argued against the Islamic financial system that the
Islamic banks and financial institutions, working since last three
decades, did not bring any visible change in the economic set-up,
not even in the field of financing. This indicates that the boastful
claims of creating 'distributive justice' under the umbrella of Islamic
banking are exaggerated.
This criticism is not realistic, because it does not take into
account the fact that, in proportion to the conventional banking,
the Islamic banks and financial institutions are no more than a small
drop in an ocean, and therefore, they cannot be supposed to
revolutionise the economy in a short period.
Secondly, these institutions are passing through their age of
infancy. They have to work under a large number of constraints,
therefore, some of them have not been able to comply with all the
requirements of Shari'ah in all their transactions, therefore, each
and every transaction carried out by them cannot be attributed to
Shari'ah.
Thirdly, the Islamic banks and financial institutions are not
normally supported by the governments, legal and taxation system
and the central banks of their respective countries. Under these
circumstances, they have been given certain concessions, on the
grounds of need or necessity, which are not based on the original
and ideal principles of Shari'ah.
Islam, being a practical way of life, has two sets of rules; one is
based on the ideal objectives of Shari'ah which is applicable in
normal conditions, and the second is based on some relaxations
given in abnormal situations. The real Islamic order is based on the
15
AN INTRODUCTION TO ISLAMIC FINANCE
former set of principles, while the latter is a concession which can be
availed at times of need, but it does not reflect the true picture of
the real Islamic order.
Living under constraints, the Islamic banks are mostly relying
on the second set of rules, therefore, their activities could not bring
a visible change even in the limited circle of their operations.
However, if the whole financing system is based on the ideal Islamic
principles, it will certainly bring a discernible impact on the
economy.
It is to be noted that the present book, being a guide book to
the present day financial institutions, has dealt with both types of
the Islamic rules. At the outset, the ideal Islamic principles of
finance have been elaborated and later on we have discussed the best
possible concessions that may be availed of in the transitory period
where the Islamic institutions are working under pressure of the
existing legal and fiscal system. Shari'ah has specific principles about
such concessions as well, and their basic purpose is to avoid clear
prohibitions by adopting a less preferable line of action. This may
not serve the basic purpose of establishing a true Islamic order, yet it
may help one refrain from a glaring sin and save him from the evil
fate of disobedience, which, in itself, is a cherished goal of a
Muslim, though at individual level. Moreover, this may help the
society to advance gradually to the ideal target of establishing a total
Islamic order. This book should be studied in the light of this
scheme of Islamic Shari'ah.
16
MUSHARAKAH
'Musharakah' is a word of Arabic origin which literally means
sharing. In the context of business and trade it means a joint
enterprise in which all the partners share the profit or loss of the
joint venture. It is an ideal alternative for the interest-based
financing with far reaching effects on both production and
distribution. In the modern capitalist economy, interest is the sole
instrument indiscriminately used in financing of every type. Since
Islam has prohibited interest, this instrument cannot be used for
providing funds of any kind. Therefore, musharakah can play a vital
role in an economy based on Islamic principles.
'Interest' predetermines a fixed rate of return on a loan
advanced by the financier irrespective of the profit earned or loss
suffered by the debtor, while musharakah does not envisage a fixed
rate of return. Rather, the return in musharakah is based on the
actual profit earned by the joint venture. The financier in an
interest-bearing loan cannot suffer loss while the financier in
musharakah can suffer loss, if the joint venture fails to produce
fruits. Islam has termed interest as an unjust instrument of
financing because it results in injustice either to the creditor or to
the debtor. If the debtor suffers a loss, it is unjust on the part of the
creditor to claim a fixed rate of return; and if the debtor earns a very
high rate of profit, it is injustice to the creditor to give him only a
small proportion of the profit leaving the rest for the debtor.
In the modern economic system, it is the banks which advance
depositors' money as loans to industrialists and traders. If
industrialists having only ten million of their own, acquire 90
million from the banks and embark on a huge profitable project, it
AN INTRODUCTION TO ISLAMIC FINANCE
means that 90% of the project has been created by the money of the
depositors while only 10% has been created by their own capital. If
this huge project brings enormous profits, only a small proportion
i.e. 14 or 15% will go to the depositors through the bank, while all
the rest will be gained by the industrialists whose real contribution
to the project is not more than 10%. Even this small proportion of
14 or 15% is taken back by the industrialists, because this
proportion is included by them in the cost of their production. The
net result is that all the profit of the enterprise is earned by the
persons whose own capital does not exceed 10% of the total
investment, while the people owning 90% of the investment get no
more than the fixed rate of interest which is often repaid by them
through the increased prices of the products. On the contrary, if in
an extreme situation, the industrialists go insolvent, their own loss is
no more than 10%, while the rest of 90% is totally borne by the
bank, and in some cases, by the depositors. In this way, the rate of
interest is the main cause for imbalances in the system of
distribution, which has a constant tendency in favor of the rich and
against the interests of the poor.
Conversely, Islam has a clear cut principle for the financier.
According to Islamic principles, a financier must determine whether
he is advancing a loan to assist the debtor on humanitarian grounds
or he desires to share his profits. If he wants to assist the debtor, he
should resist from claiming any excess on the principal of his loan,
because his aim is to assist him. However, if he wants to have a
share in the profits of his debtor, it is necessary that he should also
share him in his losses. Thus the returns of the financier in
musharakah have been tied up with the actual profits accrued
through the enterprise. The greater the profits of the enterprise, the
higher the rate of return to the financier. If the enterprise earns
enormous profits, all of it cannot be secured by the industrialist
exclusively, but they will be shared by the common people as
depositors in the bank. In this way, musharakah has a tendency to
favor the common people rather than the rich only.
This is the basic philosophy which explains why Islam has
suggested musharakah as an alternative to the interest based
financing. No doubt, musharakah embodies a number of practical
problems in its full implementation as a universal mode of
financing. It is sometimes presumed that musharakah is an old
18
MUSHARAKAH
instrument which cannot keep pace with the ever-advancing need
for speedy transactions. However, this presumption is due to the
lack of proper knowledge concerning the principles of musharakah.
In fact, Islam has not prescribed a specific form or procedure for
musharakah. Rather, it has set some broad principles which can
accommodate numerous forms and procedures. A new form or
procedure in musharakah cannot be rejected merely because it has
no precedent in the past. In fact, every new form can be acceptable
to the Shari'ah in so far as it does not violate any basic principle laid
down by the Holy Qur'an, the Sunnah or the consensus of the
Muslim jurists. Therefore, it is not necessary that musharakah be
implemented only in its traditional old form.
The present chapter contains a discussion of the basic principles
of musharakah and the way in which it can be implemented in the
context of modern business and trade. This discussion is aimed at
introducing musharakah as a modern mode of financing without
violating its basic principles in any way. Musharakah has been
introduced with reference to the books of Islamic jurisprudence,
and basic problems which may be faced in implementing it in a
modern situation. It is hoped that this brief discussion will open
new horizons for the thinking of Muslim jurists and economists and
may help implementing a true Islamic economy.
The Concept of Musharakah
'Musharakah' is a term frequently referred to in the context of
Islamic modes of financing. The connotation of this term is a little
limited than the term "shirkah" more commonly used in the Islamic
jurisprudence. For the purpose of clarity in the basic concepts, it
will be pertinent at the outset to explain the meaning of each term,
as distinguished from the other.
"Shirkah" means "sharing" and in the terminology of Islamic
Fiqh, it has been divided into two kinds:
(1) Shirkat-ul-Milk: It means joint ownership of two or more
persons in a particular property. This kind of "shirkah" may come
into existence in two different ways: Sometimes it comes into
operation at the option of the parties. For example, if two or more
persons purchase an equipment, it will be owned jointly by both of
them and the relationship between them with regard to that
19
AN INTRODUCTION TO ISLAMIC FINANCE
property is called "shirkat-ul-milk." Here this relationship has come
into existence at their own option, as they themselves elected to
purchase the equipment jointly.
But there are cases where this kind of "shirkah" comes to
operate automatically without any action taken by the parties. For
example, after the death of a person, all his heirs inherit his property
which comes into their joint ownership as an automatic
consequence of the death of that person.
(2) Shirkat-ul-'Aqd: This is the second type of Shirkah which
means "a partnership effected by a mutual contract". For the
purpose of brevity it may also be translated as "joint commercial
enterprise."
Shirkat-ul-'aqd is further divided into three kinds:
(i) Shirkat-ul-Amwal where all the partners invest some capital
into a commercial enterprise.
(ii) Shirkat-ul-A'mal where all the partners jointly undertake to
render some services for their customers, and the fee charged from
them is distributed among them according to an agreed ratio. For
example, if two persons agree to undertake tailoring services for
their customers on the condition that the wages so earned will go to
a joint pool which shall be distributed between them irrespective of
the size of work each partner has actually done, this partnership will
be a shirkat-ul-a'mal which is also called Shirkat-ut-taqabbul or
Shirkat-us-sana'i' or Shirkat-ul-abdan.
(iii) The third kind of Shirkat-ul-'aqd is Shirkat-ul-wujooh.
Here the partners have no investment at all. All they do is that they
purchase the commodities on a deferred price and sell them at spot.
The profit so earned is distributed between them at an agreed ratio.
All these modes of "Sharing" or partnership are termed as
"shirkah" in the terminology of Islamic Fiqh, while the term
"musharakah" is not found in the books of Fiqh. This term (i.e.
musharakah) has been introduced recently by those who have
written on the subject of Islamic modes of financing and it is
normally restricted to a particular type of "Shirkah", that is, the
Shirkat-ul-amwal, where two or more persons invest some of their
capital in a joint commercial venture. However, sometimes it
includes Shirkat-ul-a'mal also where partnership takes place in the
business of services.
20
MUSHARAKAH
It is evident from this discussion that the term "Shirkah" has a
much wider sense than the term "musharakah" as is being used
today. The latter is limited to the "Shirkat-ul-amwal" only, while
the former includes all types of joint ownership and those of
partnership. Table 1 will show the different kinds of "Shirkah" and
the two kinds which are called "musharakah" in the modern
terminology.
Since "musharakah" is more relevant for the purpose of our
discussion, and it is almost analogous to "Shirkat-ul-amwal", we
shall now dwell upon it, explaining at the first instance, the
traditional concept of this type of Shirkah, then giving a brief
account of its application to the concept of financing in the modern
context.
21
Table 1
SHIRKAH
Shirkat-ul- 'Aqd
(Joint Enterprise)
Shirkat-ul-Milk
(Joint Ownership)
Shirkat-ul- Wujooh
(Partnership in
goodwill)
Shirkat-ul-A 'mal
(Partnership in
services)
Shirkat-ul- Aqd
(Partnership in
trade)
Optional
Compulsory
I
MUSHARAKAH
t
The Basic Rules of Musharakah
1. Musharakah or Shirkat-ul-amwal is a relationship established by
the parties through a mutual contract. Therefore, it goes without
saying that all the necessary ingredients of a valid contract must be
present here also. For example, the parties should be capable of
entering into a contract; the contract must take place with free
consent of the parties without any duress, fraud or
misrepresentation, etc., etc.
But there are certain ingredients which are peculiar to the
contract of "musharakah". They are summarized here:
Distribution of Profit
2. The proportion of profit to be distributed between the partners
must be agreed upon at the time of effecting the contract. If no such
proportion has been determined, the contract is not valid in
Shari'ah.
3. The ratio of profit for each partner must be determined in
proportion to the actual profit accrued to the business, and not in
proportion to the capital invested by him. It is not allowed to fix a
lump sum amount for any one of the partners, or any rate of profit
tied up with his investment.
Therefore, if A and B enter into a partnership and it is agreed
between them that A shall be given Rs 10,000/- per month as his
share in the profit, and the rest will go to B, the partnership is
invalid. Similarly, if it is agreed between them that A will get 15%
of his investment, the contract is not valid. The correct basis for
distribution would be an agreed percentage of the actual profit
accrued to the business.
If a lump sum amount or a certain percentage of the investment
has been agreed for any one of the partners, it must be expressly
mentioned in the agreement that it will be subject to the final
settlement at the end of the term, meaning thereby that any amount
so drawn by any partner shall be treated as 'on account payment'
and will be adjusted to the actual profit he may deserve at the end of
the term. But if no profit is actually earned or is less than
anticipated, the amount drawn by the partner shall have to be
returned.
AN INTRODUCTION TO ISLAMIC FINANCE
Ratio of Profit
4. Is it necessary that the ratio of profit of each partner conforms to
the ratio of capital invested by him? There is a difference of opinion
among the Muslim jurists about this question.
In the view of Imam Malik and Imam Shafi'i, it is necessary for
the validity of musharakah that each partner gets the profit exactly
in the proportion of his investment. Therefore, if A has invested
40% of the total capital, he must get 40% of the profit. Any
agreement to the contrary which makes him entitled to get more or
less than 40% will render the musharakah invalid in Shari'ah.
On the contrary, the view of Imam Ahmad is that the ratio of
profit may differ from the ratio of investment if it is agreed between
the partners with their free consent. Therefore, it is permissible that
a partner with 40% of investment gets 60% or 70% of the profit,
while the other partner with 60% of investment gets only 40% or
30%.'
The third view is presented by Imam Abu Hanifah which can
be taken as a via media between the two opinions mentioned above.
He says that the ratio of profit may differ from the ratio of
investment in normal conditions. However, if a partner has put an
express condition in the agreement that he will never work for the
musharakah and will remain a sleeping partner throughout the term
of musharakah, then his share of profit cannot be more than the
ratio of his investment. 2
Sharing of Loss
But in the case of loss, all the Muslim jurists are unanimous on the
point that each partner shall suffer the loss exactly according to the
ratio of his investment. Therefore, if a partner has invested 40% of
the capital, he must suffer 40% of the loss, not more, not less, and
any condition to the contrary shall render the contract invalid.
There is a complete consensus of jurists on this principle. 3
Therefore, according to Imam Shafi'i, the ratio of the share of a
partner in profit and loss both must conform to the ratio of his
1 Ibn Qudamah, AJ-Mughni, (Beirut: Dar al-Kitab al-Arabi, 1972), 5:140.
2 Al-Kasani, Bada'i' al-Sana'i', 6:162-63.
3 Ibn Qudamah, Al-Mughni, 5:147.
24
MUSHARAKAH
investment. But according to Imam Abu Hanifah and Imam
Ahmad, the ratio of the profit may differ from the ratio of
investment according to the agreement of the partners, but the loss
must be divided between them exactly in accordance with the ratio
of capital invested by each one of them. It is this principle that has
been mentioned in the famous maxim:
o^t?^ & 3$ *g MbHkp% (M
Profit is based on the agreement of the parties, but loss is always
subject to the ratio of investment.
The Nature of the Capital
Most of the Muslim jurists are of the opinion that the capital
invested by each partner must be in liquid form. It means that the
contract of musharakah can be based only on money, and not on
commodities. In other words, the share capital of a joint venture
must be in monetary form. No part of it can be contributed in kind.
However, there are different views in this respect.
1 . Imam Malik is of the view that the liquidity of capital is not a
condition for the validity of musharakah, therefore, it is permissible
that a partner contributes to the musharakah in kind, but his share
shall be determined on the basis of evaluation according to the
market price prevalent at the date of the contract. This view is also
adopted by some Hanbali jurists.
2. Imam Abu Hanifah and Imam Ahmad are of the view that
no contribution in kind is acceptable in a musharakah. Their
standpoint is based on two reasons:
Firstly, they say that the commodities of each partner are always
distinguishable from the commodities of the other. For example, if
A has contributed one motor car to the business, and B has come
with another motor car, each one of the two cars is the exclusive
property of its original owner. Now, if the car of A is sold, its sale-
proceeds should go to A. B has no right to claim a share in its price.
Therefore, so far as the property of each partner is distinguished
from the property of the other, no partnership can take place. On
the contrary, if the capital invested by every partner is in the form of
Ibn Qudamah, Al-Mughni, 5:125.
25
AN INTRODUCTION TO ISLAMIC FINANCE
money, the share capital of each partner cannot be distinguished
from that of the other, because the units of money are not
distinguishable, therefore, they will be deemed to form a common
pool, and thus the partnership comes into existence. 5
Secondly, they say, there are a number of situations in a
contract of musharakah where the partners have to resort to
redistribution of the share-capital to each partner. If the share-
capital was in the form of commodities, such redistribution cannot
take place, because the commodities may have been sold at that
time. If the capital is repaid on the basis of its value, the value may
have increased, and there is a possibility that a partner gets all the
profit of the business, because of the appreciation in the value of the
commodities he has invested, leaving nothing for the other partner.
Conversely, if the value of those commodities decreases, there is a
possibility that one partner secures some part of the original price of
the commodity of the other partner in addition to his own
investment.
3. Imam al-Shafi'i has come with a via media between the two
points of view explained above. He says that the commodities are of
two kinds:
(i) Dhawat-ul-amthal (Qfi$>agzgc$£i.e. the commodities which,
if destroyed, can be compensated by the similar commodities in
quality and quantity e.g. wheat, rice etc. If 100 kilograms of wheat
are destroyed, they can easily be replaced by another 100 kg. of
wheat of the same quality.
(ii) Dhawat-ul-qeemah ((SftplKJ^cfei-e- the commodities which
cannot be compensated by the similar commodities, like the cattle.
Each head of sheep, for example, has its own characteristics which
cannot be found in any other head. Therefore, if somebody kills the
sheep of a person, he cannot compensate him by giving him similar
sheep. Rather, he is required to pay their price.
Now, Imam al-Shafi'i says that the commodities of the first
kind (i.e. dhawat-ul-amthal) may be contributed to the musharakah
as the share of a partner in the capital, while the commodities of the
' Al-Kasani, Bada'i' al-Sana'i', 6:59.
6 Ibn Qudamah, AJ-Mughni, 5:124-25.
26
MUSHARAKAH
second kind (i.e. the dhawat-ul-qeemah) cannot form part of the
share capital. 7
By this distinction between dhawat-ul-amthal and dhawat-ul-
qeemah, Imam al-Shafi'i has met the second objection on
'participation by commodities' as was raised by Imam Ahmad. For
in the case of dhawat-ul-amthal, redistribution of capital may take
place by giving to each partner the similar commodities he had
invested. However, the first objection remains still unanswered by
Imam al-Shafi'i.
In order to meet this objection also, Imam Abu Hanifah says
that the commodities falling under the category of dhawat-ul-
amthal can form part of the share capital only if the commodities
contributed by each partner have been mixed together, in such a
way that the commodity of one partner cannot be distinguished
from that of the other. 8
In short, if a partner wants to participate in a musharakah by
contributing some commodities to it, he can do so according to
Imam Malik without any restriction, and his share in the
musharakah shall be determined on the basis of the current market
value of the commodities, prevalent at the date of the
commencement of musharakah. According to Imam al-Shafi'i,
however, this can be done only if the commodity is from the
category of dhawat-ul-amthal.
According to Imam Abu Hanifah, if the commodities are
dhawat-ul-amthal, this can be done by mixing the commodities of
each partner together. And if the commodities are dhawat-ul-
qeemah, then, they cannot form part of the share capital.
It seems that the view of Imam Malik is more simple and
reasonable and meets the needs of the modern business. Therefore,
this view can be acted upon. 9
We may, therefore, conclude from the above discussion that the
share capital in a musharakah can be contributed either in cash or in
the form of commodities. In the latter case, the market value of the
commodities shall determine the share of the partner in the capital.
7 Ibid., 125.
8 Al-Kasani, op cit.
9 Ashraf Ali Thanawi, Imdad al-Fatawa.
27
AN INTRODUCTION TO ISLAMIC FINANCE
Management of Musharakah
The normal principle of musharakah is that every partner has a right
to take part in its management and to work for it. However, the
partners may agree upon a condition that the management shall be
carried out by one of them, and no other partner shall work for the
musharakah. But in this case the sleeping partner shall be entitled to
the profit only to the extent of his investment, and the ratio of
profit allocated to him should not exceed the ratio of his
investment, as discussed earlier.
However, if all the partners agree to work for the joint venture,
each one of them shall be treated as the agent of the other in all the
matters of the business and any work done by one of them in the
normal course of business shall be deemed to be authorized by all
the partners.
Termination of Musharakah
Musharakah is deemed to be terminated in any one of the following
events:
(1) Every partner has a right to terminate the musharakah at any
time after giving his partner a notice to this effect, whereby the
musharakah will come to an end.
In this case, if the assets of the musharakah are in cash form, all
of them will be distributed pro rata between the partners. But if the
assets are not liquidated, the partners may agree either on the
liquidation of the assets, or on their distribution or partition
between the partners as they are. If there is a dispute between the
partners in this matter i.e. one partner seeks liquidation while the
other wants partition or distribution of the non-liquid assets
themselves, the latter shall be preferred, because after the
termination of musharakah, all the assets are in the joint ownership
of the partners, and a co-owner has a right to seek partition or
separation, and no one can compel him on liquidation. However, if
the assets are such that they cannot be separated or partitioned, such
as machinery, then they shall be sold and the sale-proceeds shall be
distributed. 10
10 Ibn Qudamah, Al-Mughni, 5:133-34.
28
MUSHARAKAH
(2) If any one of the partners dies during the currency of
musharakah, the contract of musharakah with him stands
terminated. His heirs in this case, will have the option either to
draw the share of the deceased from the business, or to continue
with the contract of musharakah. 11
(3) If any one of the partners becomes insane or otherwise
becomes incapable of effecting commercial transactions, the
musharakah stands terminated.
Termination of Musharakah without Closing the
Business
If one of the partners wants termination of the musharakah, while
the other partner or partners like to continue with the business, this
purpose can be achieved by mutual agreement. The partners who
want to run the business may purchase the share of the partner who
wants to terminate his partnership, because the termination of
musharakah with one partner does not imply its termination
between the other partners. 13
However, in this case, the price of the share of the leaving
partner must be determined by mutual consent, and if there is a
dispute about the valuation of the share and the partners do not
arrive at an agreed price, the leaving partner may compel other
partners on the liquidation or on the distribution of the assets
themselves.
The question arises whether the partners can agree, while
entering into the contract of the musharakah, on a condition that
the liquidation or separation of the business shall not be effected
unless all the partners, or the majority of them wants to do so, and
that a single partner who wants to come out of the partnership shall
have to sell his share to the other partners and shall not force them
on liquidation or separation.
Most of the traditional books of Islamic Fiqh seem to be silent
on this question. However, it appears that there is no bar from the
Shari'ah point of view if the partners agree to such a condition right
11 Ibid.
12 Op cit.
13 See al-Fatawa al-Hindiyyah, 2:335-36.
29
AN INTRODUCTION TO ISLAMIC FINANCE
at the beginning of the musharakah. This is expressly permitted by
some Hanbali jurists. :
This condition may be justified, especially in the modern
situations, on the ground that the nature of business, in most cases
today, requires continuity for its success, and the liquidation or
separation at the instance of a single partner only may cause
irreparable damage to the other partners.
If a particular business has been started with huge amounts of
money which has been invested in a long term project, and one of
the partners seeks liquidation in the infancy of the project, it may be
fatal to the interests of the partners, as well as to the economic
growth of the society, to give him such an arbitrary power of
liquidation or separation. Therefore, such a condition seems to be
justified, and it can be supported by the general principle laid down
by the Holy Prophet H in his famous hadith:
f Yg $g %mg QgM f aPt^ i% j $1E£
All the conditions agreed upon by the Muslims are upheld, except
a condition which allows what is prohibited or prohibits what is
lawful.
So far the basic concept of shirkat-ul-amwal or musharakah in
its original and traditional sense have been summarized.
Now we are in a position to discuss some basic issues involved
in its application to the modern conditions as an approved mode of
financing. But it seems more pertinent to discuss these issues after
giving an introductory account of mudarabah which is another type
of profit-sharing and a typical mode of financing. Since the rules of
financing in both musharakah and mudarabah are similar and the
issues involved in their application are inter related, it will be more
useful to discuss the concept of mudarabah before embarking on
these issues.
See al-Mardawi, al-Insaf(Beimt, 1400 AH), 5:423.
30
3
MUDARABAH
"Mudarabah" is a special kind of partnership where one partner
gives money to another for investing it in a commercial enterprise.
The investment comes from the first partner who is called "rabb-ul-
maF, while the management and work is an exclusive responsibility
of the other, who is called "mudarib".
The difference between musharakah and mudarabah can be
summarized in the following points:
(1) The investment in musharakah comes from all the partners,
while in mudarabah, investment is the sole responsibility of rabb-ul-
mal.
(2) In musharakah, all the partners can participate in the
management of the business and can work for it, while in
mudarabah, the rabb-ul-mal has no right to participate in the
management which is carried out by the mudarib only.
(3) In musharakah all the partners share the loss to the extent of
the ratio of their investment while in mudarabah the loss, if any, is
suffered by the rabb-ul-mal only, because the mudarib does not
invest anything. His loss is restricted to the fact that his labor has
gone in vain and his work has not brought any fruit to him.
However, this principle is subject to a condition that the mudarib
has worked with due diligence which is normally required for the
business of that type. If he has worked with negligence or has
committed dishonesty, he shall be liable for the loss caused by his
negligence or misconduct.
(4) The liability of the partners in musharakah is normally
unlimited. Therefore, if the liabilities of the business exceed its
assets and the business goes in liquidation, all the exceeding
AN INTRODUCTION TO ISLAMIC FINANCE
liabilities shall be borne pro rata by all the partners. However, if all
the partners have agreed that no partner shall incur any debt during
the course of business, then the exceeding liabilities shall be borne
by that partner alone who has incurred a debt on the business in
violation of the aforesaid condition. Contrary to this is the case of
mudarabah. Here the liability of rabb-ul-mal is limited to his
investment, unless he has permitted the mudarib to incur debts on
his behalf.
(5) In musharakah, as soon as the partners mix up their capital
in a joint pool, all the assets of the musharakah become jointly
owned by all of them according to the proportion of their respective
investment. Therefore, each one of them can benefit from the
appreciation in the value of the assets, even if profit has not accrued
through sales.
The case of mudarabah is different. Here all the goods
purchased by the mudarib are solely owned by the rabb-ul-mal, and
the mudarib can earn his share in the profit only in case he sells the
goods profitably. Therefore, he is not entitled to claim his share in
the assets themselves, even if their value has increased.
Business of the Mudarabah
The rabb-ul-mal may specify a particular business for the mudarib,
in which case he shall invest the money in that particular business
only. This is called al-mudarabah al-muqayyadah (restricted
mudarabah) . But if he has left it open for the mudarib to undertake
whatever business he wishes, the mudarib shall be authorized to
invest the money in any business he deems fit. This type of
mudarabah is called "al-mudarabah al-mutlaqah" (unrestricted
mudarabah)
A rabbul-mal can contract mudarabah with more than one
person through a single transaction. It means that he can offer his
money to A and B both, so that each one of them can act for him as
1 However, some jurists have opined that any natural increase in the capital may
be taken as a profit distributable between the rabbul-mal and mudarib. For
example, if the capital was in the form of sheep, and lambs were born to some of
them, these lambs will be taken as profit and will be shared between the parties
according to the agreed proportions (see al-Nawawi, Rawdac al-Talibin, 5:125).
But this is a minority view.
32
MUDARABAH
mudarib and the capital of the mudarabah shall be utilized by both
of them jointly, and the share of the mudarib shall be distributed
between them according to the agreed proportion. In this case both
the mudaribs shall run the business as if they were partners inter se.
The mudarib or mudaribs, as the case may be, are authorized to
do anything which is normally done in the course of business.
However, if they want to do an extraordinary work, which is
beyond the normal routine of the traders, they cannot do so
without express permission from the rabb-ul-mal.
Distribution of the Profit
It is necessary for the validity of mudarabah that the parties agree,
right at the beginning, on a definite proportion of the actual profit
to which each one of them is entitled. No particular proportion has
been prescribed by the Shari'ah; rather, it has been left to their
mutual consent. They can share the profit in equal proportions, and
they can also allocate different proportions for the rabb-ul-mal and
the mudarib. However, they cannot allocate a lump sum amount of
profit for any party, nor can they determine the share of any party
at a specific rate tied up with the capital. For example, if the capital
is Rs. 100000/- they cannot agree on a condition that Rs. 10000/-
out of the profit shall be the share of the mudarib, nor can they say
that 20% of the capital shall be given to rabb-ul-mal. However, they
can agree on that 40% of the actual profit shall go to the mudarib
and 60% to the rabb-ul-mal or vice versa.
It is also allowed that different proportions are agreed in
different situations. For example the rabbul-mal can say to mudarib,
"If you trade in wheat, you will get 50% of the profit and if you
trade in flour, you will have 33% of the profit". Similarly, he can
say "If you do the business in your town, you will be entitled to
30% of the profit, and if you do it in another town, your share will
be 50% of the profit." 3
Apart from the agreed proportion of the profit, as determined in
the above manner, the mudarib cannot claim any periodical salary
2 Ibn Qudamah, AI-Mughni, 5:145.
3 Al-Kasani, Bada'i' al-Sana'i', 6:99.
33
AN INTRODUCTION TO ISLAMIC FINANCE
or a fee or remuneration for the work done by him for the
mudarabah. 4
All the schools of Islamic Fiqh are unanimous on this point.
However, Imam Ahmad has allowed for the mudarib to draw his
daily expenses of food only from the mudarabah account. 5
The Hanafi jurists restrict this right of the mudarib only to a
situation when he is on a business trip outside his own city. In this
case he can claim his personal expenses, accommodation, food, etc.,
but he is not entitled to get anything as daily allowances when he is
in his own city.
If the business has incurred loss in some transactions and has
gained profit in some others, the profit shall be used to offset the
loss at the first instance, then the remainder, if any, shall be
distributed between the parties according to the agreed ratio. 7
Termination of Mudarabah
The contract of mudarabah can be terminated at any time by either
of the two parties. The only condition is to give a notice to the
other party. If all the assets of the mudarabah are in cash form at the
time of termination, and some profit has been earned on the
principal amount, it shall be distributed between the parties
according to the agreed ratio. However, if the assets of the
mudarabah are not in the cash form, the mudarib shall be given an
opportunity to sell and liquidate them, so that the actual profit may
be determined. 8
There is a difference of opinion among the Muslim jurists about
the question whether the contract of mudarabah can be effected for
a specified period after which it terminates automatically. The
Hanafi and Hanbali schools are of the view that the mudarabah can
be restricted to a particular term, like one year, six months, etc, after
which it will come to an end without a notice. On the contrary,
4 Al-Sarakhsi, al-Mabsut, 22:149-50.
5 Ibn Qudamah, Al-Mughni, 5:186.
6 Al-Kasani, Bada'i' al-Sana'i', 6:109.
7 Ibn Qudamah, Al-Mughni, 5:168.
8 Al-Kasani, Bada'i' al-Sana'i', 6:109.
34
MUDARABAH
Shafi'i and Maliki schools are of the opinion that the mudarabah
cannot be restricted to a particular time. 9
However, this difference of opinion relates only to the
maximum time-limit of the mudarabah. Can a minimum time-limit
also be fixed by the parties before which mudarabah cannot be
terminated? No express answer to this question is found in the
books of Islamic Fiqh, but it appears from the general principles
enumerated therein that no such limit can be fixed, and each party
is at liberty to terminate the contract whenever he wishes.
This unlimited power of the parties to terminate the mudarabah
at their pleasure may create some difficulties in the context of the
present circumstances, because most of the commercial enterprises
today need time to bring fruits. They also demand constant and
complex efforts. Therefore, it may be disastrous to the project, if the
rabb-ul-mal terminates the mudarabah right in the beginning of the
enterprise. Specially, it may bring a severe set-back to the mudarib
who will earn nothing despite all his efforts. Therefore, if the parties
agree, when entering into the mudarabah, that no party shall
terminate it during a specified period, except in specified
circumstances, it does not seem to violate any principle of Shari'ah,
particularly in the light of the famous hadith, already quoted, which
says:
f Yg v&j %mg QgaM f aPt^ i% j $l£
All the conditions agreed upon by the Muslims are upheld, except
a condition which allows what is prohibited or prohibits what is
lawful.
Combination of Musharakah and Mudarabah
A contract of mudarabah normally presumes that the mudarib has
not invested anything to the mudarabah. He is responsible for the
management only, while all the investment comes from rabb-ul-
mal. But there may be situations where mudarib also wants to invest
some of his money into the business of mudarabah. In such cases,
musharakah and mudarabah are combined together. For example, A
9 Ibid., 6:99. See also Ibn Qudamah, al-Mughni, 5:185-86 and al-Sarakhsi, al-
Mabsm, 22:133.
35
AN INTRODUCTION TO ISLAMIC FINANCE
gave to B Rs. 100000/- in a contract of mudarabah. B added Rs.
50000/- from his own pocket with the permission of A. This type of
partnership will be treated as a combination of musharakah and
mudarabah. Here the mudarib may allocate for himself a certain
percentage of profit on account of his investment as a sharik, and at
the same time he may allocate another percentage for his
management and work as a mudarib. The normal basis for
allocation of the profit in the above example would be that B shall
secure one third of the actual profit on account of his investment,
and the remaining two thirds of the profit shall be distributed
between them equally. However, the parties may agree on any other
proportion. The only condition is that the sleeping partner should
not get more percentage than the proportion of his investment.
Therefore, in the aforesaid example, A cannot allocate for
himself more than two thirds of the total profit, because he has not
invested more than two thirds of the total capital. Short of that,
they can agree on any proportion. If they have agreed on that the
total profit will be distributed equally, it means that one third of the
profit shall go to B as an investor, while one fourth of the remaining
two thirds will go to him as a mudarib. The rest will be given to A
as "rabb-ul-mal."
10 See Ibn Qudamah, al-Mughni, 5:136-37; and al-Kasani, Bada'i' al-Sana'i'.
36
4
musharakah &
mudarabah as
Modes of Financing
In the foregoing sections, the traditional concept of musharakah
and mudarabah and the basic principles of Shari'ah governing them
have been explained. It is pertinent now to discuss the way these
instruments may be used for the purpose of financing in the context
of modern trade and industry.
The concept of musharakah and mudarabah envisaged in the
books of Islamic Fiqh generally presumes that these contracts are
meant for initiating a joint venture whereby all the partners
participate in the business right from its inception and continue to
be partners upto the end of the business when all the assets are
liquidated. One can hardly find in the traditional books of Islamic
Fiqh the concept of a running business where partners join and
leave the enterprise without affecting in any way the continuity of
the business. Obviously, the classical books of Islamic Fiqh were
written in an environment where the large scale commercial
enterprises were not in vogue and the commercial activities were not
so complex as they are today. Therefore, they did not generally
dwell upon the question of such a running business.
However, it does not mean that the concept of musharakah and
mudarabah cannot be used for financing a running business. The
concept of musharakah and mudarabah is based on some basic
AN INTRODUCTION TO ISLAMIC FINANCE
principles. As long as these principles are fully complied with, the
details of their application may vary from time to time. Let us have
a look at these basic principles before entering the details:
(1) Financing through musharakah and mudarabah does never
mean the advancing of money. It means to participation in the
business and in the case of musharakah, sharing in the assets of the
business to the extent of the ratio of financing.
(2) An investor / financier must share the loss incurred by the
business to the extent of his financing.
(3) The partners are at liberty to determine, with mutual
consent, the ratio of profit allocated to each one of them, which
may differ from the ratio of investment. However, the partner who
has expressly excluded himself from the responsibility of work for
the business cannot claim more than the ratio of his investment.
(4) The loss suffered by each partner must be exactly in the
proportion of his investment.
Keeping these broad principles in view, we proceed to see how
musharakah and mudarabah can be used in different sectors of
financing:
Project Financing
In the case of project financing, the traditional method of
musharakah or mudarabah can be easily adopted. If the financier
wants to finance the whole project, the form of mudarabah can
come into operation. If investment comes from both sides, the form
of musharakah can be adopted. In this case, if the management is
the sole responsibility of one party, while the investment comes
from both, a combination of musharakah and mudarabah can be
brought into play according to the rules already discussed.
Since musharakah or mudarabah would have been effected from
the very inception of the project, no problem with regard to the
valuation of capital should arise. Similarly, the distribution of
profits according to the normal accounting standards should not be
difficult. However, if the financier wants to withdraw from the
musharakah, while the other party wants to continue the business,
the latter can purchase the share of the former at an agreed price. In
this way the financier may get back the amount he has invested
alongwith a profit, if the business has earned a profit. The basis for
38
MUSHARAKAH & MUDARABAH AS MODES OF FINANCING
determining the price of his share shall be discussed in detail later
on (while discussing the financing of working capital).
On the other hand, the businessman can continue with his
project, either on his own or by selling the first financier's share to
some other person who can substitute the financier.
Since financial institutions do not normally want to remain
partner of a specific project for good, they can sell their share to
other partners of the project as aforesaid. If the sale of the share on
one time basis is not feasible for the lack of liquidity in the project,
the share of the financier can be divided into smaller units and each
unit can be sold after a suitable interval. Whenever a unit is sold,
the share of the financier in the project is reduced to that extent,
and when all the units are sold, the financier comes out of the
project totally.
Securitization of Musharakah
Musharakah is a mode of financing which can be securitized easily,
especially, in the case of big projects where huge amounts are
required which a limited number of people cannot afford to
subscribe. Every subscriber can be given a musharakah certificate
which represents his proportionate ownership in the assets of the
musharakah, and after the project is started by acquiring substantial
non-liquid assets, these musharakah certificates can be treated as
negotiable instruments and can be bought and sold in the secondary
market. However, trading in these certificates is not allowed when
all the assets of the musharakah are still in liquid form (i.e., in the
shape of cash or receivables or advances due from others).
For proper understanding of this point, it must be noted that
subscribing to a musharakah is different from advancing a loan. A
bond issued to evidence a loan has nothing to do with the actual
business undertaken with the borrowed money. The bond stands
for a loan repayable to the holder in any case, and mostly with
interest. The musharakah certificate, on the contrary, represents the
direct pro rata ownership of the holder in the assets of the project. If
all the assets of the joint project are in liquid form, the certificate
will represent a certain proportion of money owned by the project.
For example, one hundred certificates, having a value of Rs. one
million each, have been issued. It means that the total worth of the
39
AN INTRODUCTION TO ISLAMIC FINANCE
project is Rs. 100 million. If nothing has been purchased by this
money, every certificate will represent Rs. one million. In this case,
this certificate cannot be sold in the market except at par value,
because if one certificate is sold for more than Rs. one million, it
will mean that Rs. one million are being sold in exchange for more
than Rs. one million, which is not allowed in Shari'ah, because
where money is exchanged for money, both must be equal. Any
excess at either side is riba.
However, when the subscribed money is employed in
purchasing non-liquid assets like land, building, machinery, raw
material, furniture etc. the musharakah certificates will represent the
holders' proportionate ownership in these assets. Thus, in the above
example, one certificate will stand for one hundredth share in these
assets. In this case it will be allowed by the Shari'ah to sell these
certificates in the secondary market for any price agreed upon
between the parties which may be more than the face value of the
certificate, because the subject matter of the sale is a share in the
tangible assets and not in money only, therefore the certificates may
be taken as any other commodities which may be sold with profit or
at a loss.
In most cases, the assets of the project are a mixture of liquid
and non-liquid assets. This comes to happen when the working
partner has converted a part of the subscribed money into fixed
assets or raw material, while rest of money is still liquid. Or, the
project, after converting all its money into non-liquid assets may
have sold some of them and has acquired their sale proceeds in the
form of money. In some cases the price of its sales may have become
due on its customers but may have not yet been received. These
receivable amounts, being a debt, are also treated as liquid money.
The question arises about the rule of Shari'ah in a situation where
the assets of the project are a mixture of liquid and non-liquid
assets, whether the musharakah certificates of such a project can be
traded in? The opinions of the contemporary Muslim jurists are
different on this point. According to the traditional Shafi'i school,
this type of certificate cannot be sold. Their classic view is that
whenever there is a combination of liquid and non-liquid assets, it
40
MUSHARAKAH & MUDARABAH AS MODES OF FINANCING
cannot be sold unless the non-liquid part of the business is separated
and is sold independently. '
The Hanafi school, however, is of the opinion that whenever
there is a combination of liquid and non-liquid assets, it can be sold
and purchased for an amount greater than the amount of liquid
assets in the combination, in which case money will be taken as sold
at an equal amount and the excess will be taken as the price of the
non-liquid assets owned by the business.
Suppose, the musharakah project contains 40% non-liquid
assets i.e. machinery, fixtures etc. and 60% liquid assets, i.e. cash
and receivables. Now, each musharakah certificate having the face
value of Rs. 100/- represents Rs. 60/- worth of liquid assets, and Rs.
40/- worth of non-liquid assets. This certificate may be sold at any
price more than Rs. 60. If it is sold at Rs. 1 10/- it will mean that Rs.
60 of the price are against Rs. 60/- contained in the certificate and
Rs. 50/- is against the proportionate share in the non-liquid assets.
But it will never be allowed to sell the certificate for a price of Rs.
60/- or less, because in the case of Rs. 60/- it will not set off the
amount of Rs. 60, let alone the other assets.
According to the Hanafi view, no specific proportion of non-
liquid assets in the whole is prescribed. Therefore, even if the non-
liquid assets represent less than 50% in the whole, its trading
according to the above formula is allowed.
However, most of the contemporary scholars, including those of
Shafi'i school, have allowed trading in the units of the whole only if
the non-liquid assets of the business are more than 50%. Therefore,
for a valid trading of the musharakah certificates acceptable to all
schools, it is necessary that the portfolio of musharakah consists of
non-liquid assets valuing more than 50% of its total worth.
However, if Hanafi view is adopted, trading will be allowed even if
the non-liquid assets are less than 50%, but the size of the non-
liquid assets should not be negligible.
1 This view is based on the famous principle of "mudd al-'ajwah" explained in the
traditional books of Islamic fiqh. See for example, al-Khattabi, Ma 'dim al-Sunan,
5:23.
41
AN INTRODUCTION TO ISLAMIC FINANCE
Financing of a Single Transaction
Musharakah and mudarabah can be used more easily for financing a
single transaction. Apart from fulfilling the day to-day needs of
small traders, these instruments can be employed for financing
imports and exports. An importer can approach a financier to
finance him for that single transaction of import alone on the basis
of musharakah or mudarabah. The banks can also use these
instruments for import financing. If the letter of credit has been
opened without any margin, the form of mudarabah can be
adopted, and if the L/C is opened with some margin, the form of
musharakah or a combination of both will be relevant. After the
imported goods are cleared from the port, their sale proceeds may
be shared by the importer and the financier according to a pre-
agreed ratio.
In this case, the ownership of the imported goods shall remain
with the financier to the extent of the ratio of his investment. This
musharakah can be restricted to an agreed term, and if the imported
goods are not sold in the market up to the expiry of the term, the
importer may himself purchase the share of the financier, making
himself the sole owner of the goods. However, the sale in this case
should take place at the market rate or at a price agreed between the
parties on the date of sale, and not at pre-greed price at the time of
entering into musharakah. If the price is pre-agreed, the financier
cannot compel the client / importer to purchase it.
Similarly, musharakah will be even easier in the case of export
financing. The exporter has a specific order from abroad. The price
on which the goods will be exported is well-known before hand,
and the financier can easily calculate the expected profit. He may
finance him on the basis of musharakah or mudarabah, and may
share the amount of export bill on a pre-agreed percentage. In order
to secure himself from any negligence on the part of the exporter,
the financier may put a condition that it will be the responsibility of
the exporter to export the goods in full conformity with the
conditions of the L/C. In this case, if some discrepancies are found,
the exporter alone shall be responsible, and the financier shall be
immune from any loss due to such discrepancies, because it is
caused by the negligence of the exporter. However, being a partner
of the exporter, the financier will be liable to bear any loss which
42
MUSHARAKAH & MUDARABAH AS MODES OF FINANCING
may be caused due to any reason other than the negligence or
misconduct of the exporter.
Financing of the Working Capital
Where finances are required for the working capital of a running
business, the instrument of musharakah may be used in the
following manner:
(1) The capital of the running business may be evaluated with
mutual consent. It is already mentioned while discussing the
traditional concept of musharakah that it is not necessary, according
to Imam Malik, that the capital of musharakah is contributed in
cash form. Non-liquid assets can also form part of the capital on the
basis of evaluation. This view can be adopted here. In this way, the
value of the business can be treated as the investment of the person
who seeks finance, while the amount given by the financier can be
treated as his share of investment. The musharakah may be effected
for a particular period, like one year or six months or less. Both the
parties agree on a certain percentage of the profit to be given to the
financier, which should not exceed the percentage of his investment,
because he shall not work for the business. On the expiry of the
term, all liquid and non-liquid assets of the business are again
evaluated, and the profit may be distributed on the basis of this
evaluation.
Although, according to the traditional concept, the profit
cannot be determined unless all the assets of the business are
liquidated, yet the valuation of the assets can be treated as
"constructive liquidation" with mutual consent of the parties,
because there is no specific prohibition in Shari'ah against it. It can
also mean that the working partner has purchased the share of the
financier in the assets of the business, and the price of his share has
been determined on the basis of valuation, keeping in view the ratio
of profit allocated for him according to the terms of musharakah.
For example, the total value of the business of A is 30 units. B
finances another 20 units, raising the total worth to 50 units; 40%
having been contributed by B, and 60% by A. It is agreed that B
shall get 20% of the actual profit. At the end of the term, the total
worth of the business has increased to 100 units. Now, if the share
of B is purchased by A, he should have paid to him 40 units,
43
AN INTRODUCTION TO ISLAMIC FINANCE
because he owns 40% of the assets of the business. But in order to
reflect the agreed ratio of profit in the price of his share, the formula
of pricing will be different. Any increase in the value of the business
shall be divided between the parties in the ratio of 20% and 80%,
because this ratio was determined in the contract for the purpose of
distribution of profit.
Since the increase in the value of the business is 50 units, these
50 units are divided at the ratio of 20-80, meaning thereby that 10
units will have been earned by B. These 10 units will be added to
his original 20 units, and the price of his share will be 30 units.
In the case of loss, however, any decrease in the total value of
the assets should be divided between them exactly in the ratio of
their investment, i.e., in the ratio of 40/60. Therefore, if the value
of the business has decreased, in the above example, by 10 units
reducing the total number of units to 40, the loss of 4 units shall be
borne by B (being 40% of the loss). These 4 units shall be deducted
from his original 20 units, and the price of his share shall be
determined as 16 units.
44
Figure 2
BUSINESS
Contribution: 30 (60%)
Agreed ratio of the profit: 80%
Entitlement
A's share in the profit: 40 (80%)
A's original contribution: 30
Total Entitlement: 70
i
Original Worth
50
Raised Value
100
Profit
50
B
Contribution: 20 (40%)
Agreed ratio of the profit: 20%
Entitlement
B's share in the profit: 10 (20%)
B's original contribution: 20
Total Entitlement: 30
I
Price of the Share
Price of the Share
Sharing in the Gross Profit Only
2. Financing on the basis of musharakah according to the above
procedure may be difficult in a business having a large number of
fixed assets, particularly in a running industry, because the valuation
of all its assets and their depreciation or appreciation may create
accounting problems giving rise to disputes. In such cases,
musharakah may be applied in another way.
The major difficulties in these cases arise in the calculation of
indirect expenses, like depreciation of the machinery, salaries of the
staff etc. In order to solve this problem, the parties may agree on the
principle that, instead of net profit, the gross profit will be
distributed between the parties, that is, the indirect expenses shall
not be deducted from the distribute able profit. It will mean that all
the indirect expenses shall be borne by the industrialist voluntarily,
and only direct expenses (like those of raw material, direct labor,
electricity etc.) shall be borne by the musharakah. But since the
industrialist is offering his machinery, building and staff to the
musharakah voluntarily, the percentage of his profit may be
increased to compensate him to some extent.
This arrangement may be justified on the ground that the
clients of financial institutions do not restrict themselves to the
operations for which they seek finance from the financial
institutions. Their machinery and staff etc. is, therefore, engaged in
some other business also which may not be subject to musharakah,
and in such a case the whole cost of these expenses cannot be
imposed on the musharakah.
Let us take a practical example. Suppose a ginning factory has a
building worth Rs. 22 million, plant and machinery valuing Rs. 2
million and the staff is paid Rs. 50,000/- per month. The factory
sought finance of Rs. 5,000,000/- from a bank on the basis of
musharakah for a term of one year. It means that after one year the
musharakah will be terminated, and the profits accrued up to that
point will be distributed between the parties according to the agreed
ratio. While determining the profit, all direct expenses will be
deducted from the income. The direct expenses may include the
following:
1. the amount spent in purchasing raw material
MUSHARAKAH & MUDARABAH AS MODES OF FINANCING
2. the wages of the labor directly involved in processing the
raw material
3. the expenses for electricity consumed in the process of
ginning
4. the bills for other services directly rendered for the
musharakah
So far as the building, the machinery and the salary of other
staff is concerned, it is obvious that they are not meant for the
business of the musharakah alone, because the musharakah will
terminate within one year, while the building and the machinery are
purchased for a much longer term in which the ginning factory will
use them for its own business which is not subject to this one-year
musharakah. Therefore, the whole cost of the building and the
machinery cannot be borne by this short-term musharakah. What
can be done at the most is that the depreciation caused to the
building and the machinery during the term of the musharakah is
included in its expenses. But in practical terms, it will be very
difficult to determine the cost of depreciation, and it may cause
disputes also. Therefore, there are two practical ways to solve this
problem.
In the first instance, the parties may agree that the musharakah
portfolio will pay an agreed rent to the client for the use of the
machinery and the building owned by him. This rent will be paid to
him from the musharakah fund irrespective of profit or loss
accruing to the business.
The second option is that, instead of paying rent to the client,
the ratio of his profit is increased.
From the point of view of Shari'ah, it may be justified on the
analogy of mudarabah in services which is allowed in the view of
Imam Ahmad bin Hanbal EM! cX$30
Running Musharakah Account on the Basis of Daily Products
3. Many financial institutions finance the working capital of an
enterprise by opening a running account for them from where the
clients draw different amounts at different intervals, but at the same
time, they keep returning their surplus amounts. Thus the process
of debit and credit goes on up to the date of maturity, and the
interest is calculated on the basis of daily products.
47
AN INTRODUCTION TO ISLAMIC FINANCE
Can such an arrangement be possible under the musharakah or
mudarabah modes of financing? Obviously, being a new
phenomenon, no express answer to this question can be found in
the classical works of Islamic Fiqh. However, keeping in view the
basic principles of musharakah the following procedure may be
suggested for this purpose:
(i) A certain percentage of the actual profit must be
allocated for the management,
(ii) The remaining percentage of the profit must be
allocated for the investors.
(iii) The loss, if any, should be borne by the investors only in
exact proportion of their respective investments,
(iv) The average balance of the contributions made to the
musharakah account calculated on the basis of daily
products shall be treated as the share capital of the
financier,
(v) The profit accruing at the end of the term shall be
calculated on daily product basis, and shall be
distributed accordingly.
If such an arrangement is agreed upon between the parties, it
does not seem to violate any basic principle of the musharakah.
However, this suggestion needs further consideration and research
by the experts of Islamic jurisprudence. Practically, it means that the
parties have agreed to the principle that the profit accrued to the
musharakah portfolio at the end of the term will be divided on the
capital utilized per day, which will lead to the average of the profit
earned by each rupee per day. The amount of this average profit per
rupee per day will be multiplied by the number of the days each
investor has put his money into the business, which will determine
his profit entitlement on daily product basis.
Some contemporary scholars do not allow this method of
calculating profits on the ground that it is just a conjectural method
which does not reflect the actual profits really earned by a partner of
the musharakah, because the business may have earned huge profits
during a period when a particular investor had no money invested
in the business at all, or had a very negligible amount invested, still,
he will be treated at par with other investors who had huge amounts
invested in the business during that period. Conversely, the business
may have suffered a great loss during a period when a particular
48
MUSHARAKAH & MUDARABAH AS MODES OF FINANCING
investor had huge amounts invested in it. Still, he will pass on some
of his loss to other investors who had no investment in that period
or their size of investment was negligible.
This argument can be refuted on the ground that it is not
necessary in a musharakah that a partner should earn profit on his
own money only. Once a musharakah pool comes into existence,
the profits accruing to the joint pool are earned by all the
participants, regardless of whether their money is or is not utilized
in a particular transaction. This is particularly true of the Hanafi
School which does not deem it necessary for a valid musharakah
that the monetary contributions of the partners are mixed up
together. It means that if A has entered into a musharakah contract
with B, but has not yet disbursed his money into the joint pool, he
will still be entitled to a share in the profit of the transactions
effected by B for the musharakah through his own money.
Although his entitlement to a share in the profit will be subject to
the disbursement of money undertaken by him, yet the fact remains
that the profit of this particular transaction did not accrue to his
money, because the money disbursed by him at a later stage may be
used for another transaction. Suppose, A and B entered into a
musharakah to conduct a business of Rs. 100,000/-
They agreed that each one of them shall contribute Rs. 50,000/-
and the profits will be distributed by them equally. A did not yet
invest his Rs. 50,000/- into the joint pool. B found a profitable deal
and purchased two air-conditions for the musharakah for Rs.
50,000/- contributed by himself and sold them for Rs. 60,000/-,
thus earning a profit of Rs. 10000/-. A contributed his share of Rs.
50,000/- after this deal. The partners purchased two refrigerators
through this contribution which could not be sold at a greater price
than Rs. 48000/- meaning thereby that this deal resulted in a loss of
Rs. 2000/- Although the transaction effected by A's money brought
loss of Rs. 2000/- while the profitable deal of air-conditions was
financed entirely by B's money in which A had no contribution, yet
A will be entitled to a share in the profit of the first deal. The loss of
Rs. 2000/- in the second deal will be set off from the profit of the
first deal reducing the aggregate profit to Rs. 8000/-. This profit of
Rs. 8000/- will be shared by both partners equally. It means that A
See al-Kasani, Bada'i' al-Sana'i', 6:54, 60.
49
AN INTRODUCTION TO ISLAMIC FINANCE
will get Rs. 4000/-, even though the transaction effected by his
money has suffered loss.
The reason is that once a musharakah contract is entered into
by the parties, all the subsequent transactions effected for
musharakah belong to the joint pool, regardless of whose individual
money is utilized in them. Each partner is a party to each
transaction by virtue of his entering into the contract of
musharakah.
A possible objection to the above explanation may be that in the
above example, A had undertaken to pay Rs. 50,000/- and it was
known before hand that he will contribute a specified amount to
the musharakah. But in the proposed running account of
musharakah where the partners are coming in and going out every
day, nobody has undertaken to contribute any specific amount.
Therefore, the capital contributed by each partner is unknown at
the time of entering into musharakah, which should render the
musharakah invalid.
The answer to the above objection is that the classical scholars
of Islamic Fiqh have different views about whether it is necessary for
a valid musharakah that the capital is pre-known to the partners.
The Hanafi scholars are unanimous on the point that it is not a pre-
condition. Al-Kasani, the famous Hanafi jurist, writes:
3€fr Gsfeaj Ufl| ... PA y^i^ .Afg 6%>>fe
6^a 6 (M^(|a^5LlAQfesi Qg^/M%pz
j
*\ — •**
According to our Hanafi School, it is not a condition for the
validity of musharakah that the amount of capital is known, while
it is a condition according to Imam Shafi'i. Our argument is that
jabalab (uncertainty) in itself does not render a contract invalid,
unless it leads to disputes. And the uncertainty in the capital at
the time of musharakah does not lead to disputes, because it is
50
MUSHARAKAH & MUDARABAH AS MODES OF FINANCING
generally known when the commodities are purchased for the
musharakah, therefore it does not lead to uncertainty in the profit
at the time of distribution. 2
It is, therefore, clear from the above that even if the amount of
the capital is not known at the time of musharakah, the contract is
valid. The only condition is that it should not lead to the
uncertainty in the profit at the time of distribution. Distribution of
profit on daily product basis fulfills this condition.
It is true that the concept of a running musharakah where the
partners at times draw some amounts and at other times inject new
money and the profits are calculated on daily products basis is not
found in the classical books of Islamic Fiqh. But merely this fact
cannot render a new arrangement invalid in Shari'ah, so far as it
does not violate any basic principle of musharakah. In the proposed
system, all the partners are treated at par. The profit of each partner
is calculated on the basis of the period for which his money
remained in the joint pool. There is no doubt in the fact that the
aggregate profits accrued to the pool are generated by the joint
utilization of different amounts contributed by the participants at
different times. Therefore, if all of them agree with mutual consent
to distribute the profits on daily products basis, there is no
injunction of Shari'ah which makes it impermissible; rather, it is
covered under the general guideline given by the Holy Prophet H
in his famous hadith quoted in this book more than once:
f Yg % %mg GgatA f a0Q$ i%\ $l£
All the conditions agreed upon by the Muslims are upheld, except
a condition which allows what is prohibited or prohibits what is
lawful.
If distribution on daily products basis is not accepted, it will
mean that no partner can draw any amount from, nor can he inject
new amounts to the joint pool. Similarly, nobody will be able to
subscribe to the joint pool except at the particular dates of the
commencement of a new term. This arrangement is totally
impracticable on the deposits side of the banks and financial
' Al-Kasani, Bada'i' al-Sana'i', 6:63.
51
AN INTRODUCTION TO ISLAMIC FINANCE
institutions where the accounts are debited and credited by the
depositors many times a day. The rejection of the concept of the
daily products will compel them to wait for months before they
deposit their surplus money in a profitable account. This will hinder
the utilization of savings for development of industry and trade, and
will keep the wheel of financial activities jammed for long periods.
There is no other solution for this problem except to apply the
method of daily products for the calculation of profits, and since
there is no specific injunction of Shari'ah against it, there is no
reason why this method should not be adopted.
Some Objections on Musharakah Financing
Let us now examine some objections raised from practical point of
view against using musharakah as a mode of financing.
Risk of Loss
It is argued that the arrangement of musharakah is more likely to
pass on losses of the business to the financier bank or institution.
This loss will be passed on to depositors also. The depositors, being
constantly exposed to the risk of loss, will not want to deposit their
money in the banks and financial institutions and thus their savings
will either remain idle or will be used in transactions outside of the
banking channels, which will not contribute to the economic
development at national level.
This argument is, however, misconceived. Before financing on
the basis of musharakah, the banks and financial institution will
study the feasibility of the proposed business for which funds are
needed. Even in the present system of interest-based loans the banks
do not advance loans to each and every applicant. They study the
potentials of the business and if they apprehend that the business is
not profitable, they refuse to advance a loan. In the case of
musharakah, they will have to carry out this study with more depth
and precaution.
Moreover, no bank or financial institution can restrict itself to a
single musharakah. There will always be a diversified portfolio of
musharakah. If a bank has financed 100 of its clients on the basis of
musharakah, after studying the feasibility of the proposal of each
one of them, it is hardly conceivable that all of these musharakahs
52
MUSHARAKAH & MUDARABAH AS MODES OF FINANCING
or the majority of them will result in a loss. After taking proper
measures and due care, what can happen at the most is that some
and them make a loss. But on the other hand, the profitable
musharakahs are expected to give more return than the interest-
based loans, because the actual profit is supposed to be distributed
between the client and the bank. Therefore, the musharakah
portfolio, as a whole, is not expected to suffer loss, and the
possibility of loss to the whole portfolio is merely a theoretical
possibility which should not discourage the depositors. This
theoretical possibility of loss in a financial institution is much less
than the possibility of loss in a joint stock company whose business
is restricted to a limited sector of commercial activities. Still, the
people purchase its shares and the possibility of loss does not refrain
them from investing in these shares. The case of the bank and
financial institutions is much stronger, because their musharakah
activities will be so diversified that any possible loss in one
musharakah will be more than compensated by the profits earned in
other musharakahs.
Apart from this, 'an Islamic economy must create a mentality
which believes that any profit earned on money is the reward of
bearing risks of the business. This risk may be minimized through
expertise and diversifying the portfolio where it becomes a
hypothetical or theoretical risk only. But there is no way to
eliminate this risk totally. The one who wants to earn profit, must
accept this minimal risk. Since this understanding is already there in
the case of normal joint stock companies, nobody has ever raised the
objection that the money of the shareholders is exposed to loss. The
problem is created by the system which separates the banking and
financing from the normal trade activities, and which has compelled
the people to believe that banks and financial institutions deal in
money and papers only, and that they have nothing to do with the
actual results emerging in trade and industry. Therefore, it is argued
that they deserve a fixed return in any case. This separation of
financing sector from the sector of trade and industry has brought
great harms to the economy at macro-level. Obviously, when we
speak of Islamic banking, we never mean that it will follow this
conventional system in each and every respect. Islam has its own
values and principles which do not believe in separation of
financing from trade and industry. Once this Islamic system is
53
AN INTRODUCTION TO ISLAMIC FINANCE
understood, the people will invest in the financing sector, despite
the theoretical risk of loss, more readily than they invest in the
profitable joint stock companies.
Dishonesty
Another apprehension against musharakah financing is that the
dishonest clients may exploit the instrument of musharakah by not
paying any return to the financiers. They can always show that the
business did not earn any profit. Indeed, they can claim that it has
suffered a loss in which case not only the profit, but also the
principal amount will be jeopardized.
It is, no doubt, a valid apprehension, especially in societies
where corruption is the order of the day. However, solution to this
problem is not as difficult as is generally believed or exaggerated.
If all the banks in a country are run on pure Islamic pattern
with a careful support from the Central Bank and the government,
the problem of dishonesty is not hard to overcome. First of all, a
well-designed system of auditing should be implemented whereby
the accounts of all the clients are fully maintained and properly
controlled. It is already discussed that the profits may be calculated
to the basis of gross margins only. It will reduce the possibility of
disputes and misappropriation. However, if any misconduct,
dishonesty or negligence is established against a client, he will be
subjected to punitive steps, and may be deprived of availing any
facility from any bank in the country, at least for a specified period.
These steps will serve as strong deterrent against concealing the
actual profits or committing any other act of dishonesty. Otherwise
also, the clients of the banks cannot afford to show artificial losses
constantly, because it will be against their own interest in many
respects. It is true that even after taking all such precautions, there
will remain a possibility of some cases where dishonest clients may
succeed in their evil designs, but the punitive steps and the general
atmosphere of the business will gradually reduce the number of such
cases (Even in an interest-based economy, the defaulters have always
been creating the problem of bad debts) But it should not be taken
as a justification, or as an excuse, for rejecting the whole system of
musharakah.
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MUSHARAKAH & MUDARABAH AS MODES OF FINANCING
Undoubtedly, the apprehension of dishonesty is more severe for
the Islamic Banks and Financial institutions working in isolation
from the main stream of conventional banks. They have not much
support from their respective governments and central Banks. They
cannot change the system, nor can they impose their own laws and
regulations. However, they should not forget that they are not just
commercial institutions. They have been established to introduce a
new system of banking which has its own philosophy. They are
duty bound to promote this new system, even if they apprehend
that it will reduce the size of their profits to some extent. Therefore,
they should start using the instrument of musharakah, at least on a
selective basis. Each and every bank has a number of clients whose
integrity is beyond all doubts. The Islamic banks should, at least,
start financing them on the basis of true musharakah. It will help
setting good precedents in the market and induce others to follow
suit. Moreover, there are some sectors of financing where
musharakah can be used easily. For example, the use of musharakah
instrument in financing exports has not much room for dishonesty.
The exporter has a specific order from abroad. The prices are
agreed. The cost is not difficult to determine. Payments are
normally secured by a letter of credit. The payments are made
through the bank itself. There is no reason in such cases why the
musharakah arrangement should not be adopted. Similarly,
financing of imports may also be designed on the basis of
musharakah with some precautions, as explained earlier in this
chapter.
Secrecy of the Business
Another criticism against musharakah is that, by making the
financier a partner in the business of the client, it may disclose the
secrets of the business to the financier, and through him to other
traders.
However, the solution to this problem is very easy. The client,
while entering into the musharakah, may put a condition that the
financier will not interfere with the management affairs, and he will
not disclose any information about the business to any person
without prior permission of the client. Such agreements of
maintaining secrecy are always honored by the prestigious
55
AN INTRODUCTION TO ISLAMIC FINANCE
institutions, especially by the banks and financial institutions whose
entire business is based on confidentiality.
Clients' Unwillingness to Share Profits
Many a time, it is mentioned that the clients are not willing to share
with the Banks the actual profits of their business. The reluctance is
based on two reasons:
1 . They think that the bank has no right to share in the actual
profit, which may be substantial, because the bank has
nothing to do with the management or running of the
business and why should they (the clients) share the fruit of
their labour with the Bank who merely provides funds. The
Clients also argue that conventional banks are content with
a meagre rate of interest and so should be the Islamic Banks.
2. Even if the above was not a factor, the Clients are afraid to
reveal their true profits to the Banks, lest the information is
also passed on to the tax authorities and Clients' tax liability
increases.
The solution to the first part, though not easy, is not difficult or
impossible either. Such Clients need to be convinced and persuaded
that borrowing on interest is a cardinal sin, unless there is a dire
necessity for such borrowing. Mere expansion of business is not a
dire need, by any stretch of imagination. By making a legitimate
arrangement for obtaining funds for their business, by way of
musharakah, not only do they earn Allah's pleasure but also a
legitimate return for themselves, as well as for the Islamic Banks.
In respect of the second factor, all that can be said is that in
some muslim countries, rate of taxation are indeed prohibitive and
unjust. Islamic Banks as well as their Clients must lobby with the
governments and struggle to change the laws which hamper the
progress towards Islamic banking. The governments should also try
to appreciate the fact that if rates of taxation are reasonable and if
the tax-payers are convinced that they will benefit by honestly
paying their taxes, this would increase, and not decrease,
government revenues.
56
MUSHARAKAH & MUDARABAH AS MODES OF FINANCING
Diminishing Musharakah
Another form of musharakah, developed in the near past, is
'diminishing musharakah'. According to this concept, a financier
and his client participate either in the joint ownership of a property
or an equipment, or in a joint commercial enterprise. The share of
the financier is further divided into a number of units and it is
understood that the client will purchase the units of the share of the
financier one by one periodically, thus increasing his own share till
all the units of the financier are purchased by him so as to make
him the sole owner of the property, or the commercial enterprise, as
the case may be.
The diminishing musharakah based on the above concept has
taken different shapes in different transactions. Some examples are
given below:
1. It has been used mostly in house financing. The client wants
to purchase a house for which he does not have adequate
funds. He approaches the financier who agrees to participate
with him in purchasing the required house. 20% of the
price is paid by the client and 80% of the price by the
financier. Thus the financier owns 80% of the house while
the client owns 20%. After purchasing the property jointly,
the client uses the house for his residential requirement and
pays rent to the financier for using his share in the property.
At the same time the share of financier is further divided in
eight equal units, each unit representing 10% ownership of
the house. The client promises to the financier that he will
purchase one unit after three months. Accordingly, after the
first term of three months he purchases one unit of the share
of the financier by paying l/10th of the price of the house.
It reduces the share of the financier from 80% to 70%.
Hence, the rent payable to the financier is also reduced to
that extent. At the end of the second term, he purchases
another unit increasing his share in the property to 40% and
reducing the share of the financier to 60% and
consequentially reducing the rent to that proportion. This
process goes on in the same fashion until after the end of
two years, the client purchases the whole share of the
57
AN INTRODUCTION TO ISLAMIC FINANCE
financier reducing the share of the financier to 'zero' and
increasing his own share to 100%.
This arrangement allows the financier to claim rent
according to his proportion of ownership in the property
and at the same time allows him periodical return of a part
of his principal through purchases of the units of his share.
2. 'A' wants to purchase a taxi to use it for offering transport
services to passengers and to earn income through fares
recovered from them, but he is short of funds. 'B' agrees to
participate in the purchase of the taxi, therefore, both of
them purchase a taxi jointly. 80% of the price is paid by 'B'
and 20% is paid by 'A'. After the taxi is purchased, it is
employed to provide transport to the passengers whereby
the net income of Rs. 1000/- is earned on daily basis. Since
'B' has 80% share in the taxi it is agreed that 80% of the
fare will be given to him and the rest of 20% will be
retained by A' who has a 20% share in the taxi. It means
that Rs. 800/- is earned by 'B' and Rs. 200/- by A' on daily
basis. At the same time the share of 'B' is further divided
into eight units. After three months A' purchases one unit
from the share of 'B'. Consequently the share of 'B' is
reduced to 70% and share of A' is increased to 30%
meaning thereby that as from that date A' will be entitled
to Rs. 300/- from the daily income of the taxi and 'B' will
earn Rs. 700/-. This process will go on until after the expiry
of two years, the whole taxi will be owned by A' and 'B' will
take back his original investment along with income
distributed to him as aforesaid.
3. A' wishes to start the business of ready-made garments but
lacks the required funds for that business. 'B' agrees to
participate with him for a specified period, say two years.
40% of the investment is contributed by A' and 60% by
'B'. Both start the business on the basis of musharakah. The
proportion of profit allocated for each one of them is
expressly agreed upon. But at the same time 'B's share in the
business is divided to six equal units and A' keeps
purchasing these units on gradual basis until after the end of
two years 'B' comes out of the business, leaving its exclusive
58
MUSHARAKAH & MUDARABAH AS MODES OF FINANCING
ownership to 'A'. Apart from periodical profits earned by
'B', he gains the price of the units of his share which, in
practical terms, tend to repay to him the original amount
invested by him.
Analyzed from the Shari'ah point of view this arrangement is
composed of different transactions which come to play their role at
different stages. Therefore, each one of the foregoing three forms of
diminishing musharakah is discussed below in the light of the
Islamic principles:
House Financing on the Basis of Diminishing
Musharakah
The proposed arrangement is composed of the following
transactions:
1. To create joint ownership in the property (Shirkat-al-Milk) .
2. Giving the share of the financier to the client on rent.
3. Promise from the client to purchase the units of share of the
financier.
4. Actual purchase of the units at different stages.
5. Adjustment of the rental according to the remaining share
of the financier in the property.
Let me discuss each ingredient of the arrangement in a greater
detail.
i) The first step in the above arrangement is to create a joint
ownership in the property. It has already been explained in the
beginning of this chapter that 'Shirkat-al-Milk' (joint ownership)
can come into existence in different ways including joint purchase
by the parties. This has been expressly allowed by all schools of
Islamic jurisprudence. 3 Therefore no objection can be raised against
creating this joint ownership.
ii) The second part of the arrangement is that the financier
leases his share in the house to his client and charges rent from him.
3 See for example Radd al-Muhtar, 3:364-365.
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AN INTRODUCTION TO ISLAMIC FINANCE
This arrangement is also above board because there is no difference
of opinion among the Muslim jurists in the permissibility of leasing
one's undivided share in a property to his partner. If the undivided
share is leased out to a third party its permissibility is a point of
difference between the Muslim jurists. Imam Abu Hanifah and
Imam Zufar are of the view that the undivided share cannot be
leased out to a third party, while Imam Malik and Imam Shafi'i,
Abu Yusuf and Muhammad Ibn Hasan hold that the undivided
share can be leased out to any person. But so far as the property is
leased to the partner himself, all of them are unanimous on the
validity of 'ijarah'. 4
iii) The third step in the aforesaid arrangement is that the client
purchases different units of the undivided share of the financier.
This transaction is also allowed. If the undivided share relates to
both land and building, the sale of both is allowed according to all
the Islamic schools. Similarly if the undivided share of the building
is intended to be sold to the partner, it is also allowed unanimously
by all the Muslim jurists. However, there is a difference of opinion
if it is sold to the third party. 5
It is clear from the foregoing three points that each one of the
transactions mentioned hereinabove is allowed per se, but the
question is whether this transaction may be combined in a single
arrangement. The answer is that if all these transactions have been
combined by making each one of them a condition to the other,
then this is not allowed in Shari'ah, because it is a well settled rule
in the Islamic legal system that one transaction cannot be made a
pre-condition for another. However, the proposed scheme suggests
that instead of making two transactions conditional to each other,
there should be one sided promise from the client, firstly, to take
share of the financier on lease and pay the agreed rent, and
secondly, to purchase different units of the share of the financier of
the house at different stages. This leads us to the fourth issue, which
is, the enforceability of such a promise.
iv) It is generally believed that a promise to do something
creates only a moral obligation on the promisor which cannot be
enforced through courts of law. However, there are a number of
4 See Ibn Qudamah, Al-Mughni, 6:137; and Radd al-Muhcar, 6:47, 48.
5 See Radd al-Muhtar, 3:365.
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MUSHARAKAH & MUDARABAH AS MODES OF FINANCING
Muslim jurists who opine that promises are enforceable, and the
court of law can compel the promisor to fulfil his promise,
especially, in the context of commercial activities. Some Maliki and
Hanafi jurists can be cited, in particular, who have declared that the
promises can be enforced through courts of law in cases of need.
The Hanafi jurists have adopted this view with regard to a particular
sale called 'bai-bilwafa'. This bai-bilwafa is a special arrangement of
sale of a house whereby the buyer promises to the seller that
whenever the latter gives him back the price of the house, he will
resell the house to him. This arrangement was in vogue in countries
of central Asia, and the Hanafi jurists have opined that if the resale
of the house to the original seller is made a condition for the initial
sale, it is not allowed. However, if the first sale is effected without
any condition, but after effecting the sale, the buyer promises to
resell the house whenever the seller offers to him the same price, this
promise is acceptable and it creates not only a moral obligation, but
also an enforceable right of the original seller. The Muslim jurists
allowing_ this arrangement have based their view on the principle
that aJbfi(foOZ.QtliW /B^jpCbMVfifp (the promise can be made
enforceable at the time of need).
Even if the promise has been made before effecting the first sale,
after which the sale has been effected without a condition, it is also
allowed by certain Hanafi jurists.
One may raise an objection that if the promise of resale has
been taken before entering into an actual sale, it practically amounts
to putting a condition on the sale itself, because the promise is
understood to have been entered into between the parties at the
time of sale, and therefore, even if the sale is without an express
condition, it should be taken as conditional because a promise in an
express term has preceded it.
This objection can be answered by saying that there is a big
difference between putting a condition in the sale and making a
separate promise without making it a condition. If the condition is
expressly mentioned at the time of sale, it means that the sale will be
valid only if the condition is fulfilled, meaning thereby that if the
condition is not fulfilled in future, the present sale will become
See Jami" al-Fusulain, 2:237 and Radd al-Muhtar, 4:135.
61
AN INTRODUCTION TO ISLAMIC FINANCE
void. This makes the transaction of sale contingent on a future
event which may or may not occur. It leads to uncertainty (gharar)
in the transaction which is totally prohibited in Shari'ah.
Conversely, if the sale is without any condition, but one of the
two parties has promised to do something separately, then the sale
cannot be held to be contingent or conditional with fulfilling of the
promise made. It will take effect irrespective of whether or not the
promisor fulfils his promise. Even if the promisor backs out of his
promise, the sale will remain effective. The most the promise can do
is to compel the promisor through court of law to fulfil his promise
and if the promisor is unable to fulfil the promise, the promise can
claim actual damages he has suffered because of the default.
This makes it clear that a separate and independent promise to
purchase does not render the original contract conditional or
contingent. Therefore, it can be enforced.
On the basis of this analysis, diminishing musharakah may be
used for House Financing with following conditions:
a) The agreement of joint purchase, leasing and selling different
units of the share of the financier should not be tied-up together in
one single contract. However, the joint purchase and the contract of
lease may be joined in one document whereby the financier agrees
to lease his share, after joint purchase, to the client. This is allowed
because, as explained in the relevant chapter, ijarah can be effected
for a future date. At the same time the client may sign one-sided
promise to purchase different units of the share of the financier
periodically and the financier may undertake that when the client
will purchase a unit of his share, the rent of the remaining units will
be reduced accordingly.
b) At the time of the purchase of each unit, sale must be effected
by the exchange of offer and acceptance at that particular date.
c) It will be preferable that the purchase of different units by the
client is effected on the basis of the market value of the house as
prevalent on the date of purchase of that unit, but it is also
permissible that a particular price is agreed in the promise of
purchase signed by the client.
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MUSHARAKAH & MUDARABAH AS MODES OF FINANCING
Diminishing Musharakah for Carrying Business
of Services
The second example given above for diminishing musharakah is the
joint purchase of a taxi run for earning income by using it as a hired
vehicle. This arrangement consists of the following ingredients:
i) Creating joint ownership in a taxi in the form of Shirkah al-
Milk. As already stated this is allowed in Shari'ah.
ii) Musharakah in the income generated through the services of
taxi. It is also allowed as mentioned earlier in this chapter.
iii) Purchase of different units of the share of the financier by
the client. This is again subject to the conditions already detailed in
the case of House financing. However, there is a slight difference
between House financing and the arrangement suggested in this
second example. The taxi, when used as a hired vehicle, normally
depreciates in value over time, therefore, depreciation in the value of
taxi must be kept in mind while determining the price of different
units of the share of the financier.
Diminishing Musharakah in Trade
The third example of diminishing musharakah as given above is that
the financier contributes 60% of the capital for launching a business
of ready made garments, for example. This arrangement is
composed of two ingredients only:
1) In the first place, the arrangement is simply a musharakah
whereby two partners invest different amounts of capital in a joint
enterprise. This is obviously permissible subject to the conditions of
musharakah already spelled out earlier in this chapter.
2) Purchase of different units of the share of the financier by the
client. This may be in the form of a separate and independent
promise by the client. The requirements of Shari'ah regarding this
promise are the same as explained in the case of House financing
with one very important difference. Here the price of units of the
financier cannot be fixed in the promise to purchase, because if the
price is fixed before hand at the time of entering into musharakah,
it will practically mean that the client has ensured the principal
invested by the financier with or without profit, which is strictly
prohibited in the case of musharakah. Therefore, there are two
options for the financier about fixing the price of his units to be
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AN INTRODUCTION TO ISLAMIC FINANCE
purchased by the client. One option is that he agrees to sell the
units on the basis of valuation of the business at the time of the
purchase of each unit. If the value of the business has increased, the
price will be higher and if it has decreased the price will be less.
Such valuation may be carried out in accordance with the
recognized principles through the experts, whose identity may be
agreed upon between the parties when the promise is signed. The
second option is that the financier allows the client to sell these
units to any body else at whatever price he can, but at the same time
he offers a specific price to the client, meaning thereby that if he
finds a purchaser of that unit at a higher price, he may sell it to him,
but if he wants to sell it to the financier, the latter will be agreeable
to purchase it at the price fixed by him before hand.
Although both these options are available according to the
principles of Shari'ah, the second option does not seem to be
feasible for the financier, because it would lead to injecting new
partners in the musharakah which will disturb the whole
arrangement and defeat the purpose of diminishing musharakah in
which the financier wants to get his money back within a specified
period. Therefore, in order to implement the objective of
diminishing musharakah, only the first option is practical.
64
5
MURABAHAH
Introduction
Most of the Islamic banks and financial institutions are using
murabahah as an Islamic mode of financing, and most of their
financing operations are based on murabahah. That is why this term
has been taken in the economic circles today as a method of
banking operations, while the original concept of murabahah is
different from this assumption.
"Murabahah" is, in fact, a term of Islamic Fiqh and it refers to a
particular kind of sale having nothing to do with financing in its
original sense. If a seller agrees with his purchaser to provide him a
specific commodity on a certain profit added to his cost, it is called
a murabahah transaction. The basic ingredient of murabahah is that
the seller discloses the actual cost he has incurred in acquiring the
commodity, and then adds some profit thereon. This profit may be
in lump sum or may be based on a percentage.
The payment in the case of murabahah may be at spot, and may
be on a subsequent date agreed upon by the parties. Therefore,
murabahah does not necessarily imply the concept of deferred
payment, as generally believed by some people who are not
acquainted with the Islamic jurisprudence and who have heard
about murabahah only in relation with the banking transactions.
Murabahah, in its original Islamic connotation, is simply a sale.
The only feature distinguishing it from other kinds of sale is that
the seller in murabahah expressly tells the purchaser how much cost
AN INTRODUCTION TO ISLAMIC FINANCE
he has incurred and how much profit he is going to charge in
addition to the cost.
If a person sells a commodity for a lump sum price without any
reference to the cost, this is not a murabahah, even though he is
earning some profit on his cost because the sale is not based on a
"cost-plus" concept. In this case, the sale is called "musawamah."
This is the actual sense of the term "murabahah" which is a sale,
pure and simple. However, this kind of sale is being used by the
Islamic banks and financial institutions by adding some other
concepts to it as a mode of financing. But the validity of such
transactions depends on some conditions which should be duly
observed to make them acceptable in Shari'ah.
In order to understand these conditions correctly, one should,
in the first instance, appreciate that murabahah is a sale with all its
implications, and that all the basic ingredients of a valid sale should
be present in murabahah also. Therefore, this discussion will start
with some fundamental rules of sale without which a sale cannot be
held as valid in Shari'ah. Then, we shall discuss some special rules
governing the sale of murabahah in particular, and in the end the
correct procedure for using the murabahah as an acceptable mode of
financing will be explained.
An attempt has been made to reduce the detailed principles into
concise notes in the shortest possible sentences, so that the basic
points of the subject may be grasped at in one glance, and may be
preserved for easy reference.
Some Basic Rules of Sale
'Sale' is defined in Shari'ah as 'the exchange of a thing of value by
another thing of value with mutual consent'. Islamic jurisprudence
has laid down enormous rules governing the contract of sale, and
the Muslim jurists have written a large number of books, in a
number of volumes, to elaborate them in detail. What is meant here
is to give a summary of only those rules which are more relevant to
the transactions of murabahah as carried out by the financial
institutions:
Rule 1. The subject of sale must be existing at the time of sale.
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MURABAHAH
Thus, a thing which has not yet come into existence cannot be sold.
If a non-existent thing has been sold, though by mutual consent,
the sale is void according to Shari'ah.
Example: A sells the unborn calf of his cow to B. The sale is
void.
Rule 2. The subject of sale must be in the ownership of the seller at
the time of sale.
Thus, what is not owned by the seller cannot be sold. If he sells
something before acquiring its ownership, the sale is void.
Example: A sells to B a car which is presently owned by C, but
A is hopeful that he will buy it from C and shall deliver it to B
subsequently. The sale is void, because the car was not owned
by A at the time of sale.
Rule 3. The subject of sale must be in the physical or constructive
possession of the seller when he sells it to another person.
"Constructive possession" means a situation where the possessor has
not taken the physical delivery of the commodity, yet the
commodity has come into his control, and all the rights and
liabilities of the commodity are passed on to him, including the risk
of its destruction.
Examples:
(i) A has purchased a car from B. B has not yet delivered it to A
or to his agent. A cannot sell the car to C. If he sells it before
taking its delivery from B, the sale is void.
(ii) A has purchased a car from B. B, after identifying the Car
has placed it in a garage to which A has free access and B has
allowed him to take the delivery from that place whenever he
wishes. Thus the risk of the Car has passed on to A.. The car is
in the constructive possession of A. If A sells the car to C
without acquiring physical possession, the sale is valid.
Explanation 1:
The gist of the rules mentioned in paragraphs 1 to 3 is that a
person cannot sell a commodity unless:
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AN INTRODUCTION TO ISLAMIC FINANCE
(a) It has come into existence.
(b) It is owned by the seller.
(c) It is in the physical or constructive possession of the seller.
Explanation 2:
There is a big difference between an actual sale and a mere
promise to sell. The actual sale cannot be effected unless the
above three conditions are fulfilled. However one can promise
to sell something which is not yet owned or possessed by him.
This promise initially creates only a moral obligation on the
promisor to fulfil his promise, which is normally not justifiable.
Nevertheless, in certain situations, specially where such promise
has burdened the promise with some liability, it can be
enforceable through the courts of law. In such cases the court
may force the promisor to fulfil his promise, i.e. to effect the
sale, and if he fails to do so, the court may order him to pay the
promise the actual damages he has incurred due to the default of
the promisor.
But the actual sale will have to be effected after the
commodity comes into the possession of the seller. This will
require separate offer and acceptance, and unless the sale is
effected in this manner, the legal consequences of the sale shall
not follow.
Exception:
The rules mentioned in paragraphs 1 to 3 are relaxed with
respect to two types of sale, namely:
(a) Bai' Salam
(b) Istisna'
The rules of these two types will be discussed later in a separate
chapter.
Rule 4. The sale must be instant and absolute.
Thus a sale attributed to a future date or a sale contingent on a
future event is void. If the parties wish to effect a valid sale, they will
1 Resolution no. 2, 3 of the Fifth Session of the Islamic Fiqh Academy held in
Kuwait in the year 1409 AH. See o-UJI a*JI i^^UVl -dill £^ <L^ 2:1599.
68
MURABAHAH
have to effect it afresh when the future date comes or the
contingency actually occurs.
Examples:
(a) A says to B on the first of January: "I sell my car to you on
the first of February". The sale is void, because it is attributed to
a future date.
(b) A says to B, "If party X wins the elections, my car stands
sold to you". The sale is void, because it is contingent on a
future event.
Rule 5. The subject of sale must be a property of value.
Thus, a thing having no value according to the usage of trade
cannot be sold or purchased.
Rule 6. The subject of sale should not be a thing which is not used
except for a haram purpose, like pork, wine etc.
Rule 7. The subject of sale must be specifically known and
identified to the buyer.
Explanation:
The subject of sale may be identified either by pointation or by
detailed specification which can distinguish it from other things
not sold.
Example:
There is a building comprising a number of apartments built in
the same pattern. A, the owner of the building says to B, "I sell
one of these apartments to you"; B accepts. The sale is void
unless the apartment intended to be sold is specifically identified
or pointed out to the buyer.
Rule 8. The delivery of the sold commodity to the buyer must be
certain and should not depend on a contingency or chance.
Example: A sells his car stolen by some anonymous person and
the buyer purchases it under the hope that he will manage to
take it back. The sale is void.
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AN INTRODUCTION TO ISLAMIC FINANCE
Rule 9. The certainty of price is a necessary condition for the
validity of a sale. If the price is uncertain, the sale is void.
Example: A says to B, "If you pay within a month, the price is
Rs. 50. But if you pay after two months, the price is Rs. 55". B
agrees. The price is uncertain and the sale is void, unless anyone
of the two alternatives is agreed upon by the parties at the time
of sale.
Rule 10. The sale must be unconditional. A conditional sale is
invalid, unless the condition is recognized as a part of the
transaction according to the usage of trade.
Examples:
(1) A buys a car from B with a condition that B will employ his
son in his firm. The sale is conditional, hence invalid.
(2) A buys a refrigerator from B, with a condition that B
undertakes its free service for 2 years. The condition, being
recognized as a part of the transaction, is valid and the sale is
lawful.
Bai' Mu'ajjal (Sale on Deferred Payment Basis)
1 . A sale in which the parties agree that the payment of price
shall be deferred is called a " Bai' 'Mu'ajjal'' '.
2. Bai' Mu'ajjal is valid if the due date of payment is fixed in an
unambiguous manner.
3. The due time of payment can be fixed either with reference
to a particular date, or by specifying a period, like three months, but
it cannot be fixed with reference to a future event the exact date of
which is unknown or is uncertain. If the time of payment is
unknown or uncertain, the sale is void.
4. If a particular period is fixed for payment, like one month, it
will be deemed to commence from the time of delivery, unless the
parties have agreed otherwise.
5.. The deferred price may be more than the cash price, but it
must be fixed at the time of sale.
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MURABAHAH
6. Once the price is fixed, it cannot be decreased in case of
earlier payment, nor can it be increased in case of default.
7. In order to pressurize the buyer to pay the installments
promptly, the buyer may be asked to promise that in case of default,
he will donate some specified amount for a charitable purpose. In
this case the seller may receive such amount from the buyer, not to
make it a part of his income, but to use it for a charitable purpose
on behalf of the buyer. The detailed discussion on this subject will
be found later in this chapter.
8. If the commodity is sold on installments, the seller may put a
condition on the buyer that if he fails to pay any installment on its
due date, the remaining installments will become due immediately.
9. In order to secure the payment of price, the seller may ask the
buyer to furnish a security whether in the form of a mortgage or in
the form of a lien or a charge on any of his existing assets.
10. The buyer can also be asked to sign a promissory note or a
bill of exchange, but the note or the bill cannot be sold to a third
party at a price different from its face value.
Murabahah
1. Murabahah is a particular kind of sale where the seller
expressly mentions the cost of the sold commodity he has incurred,
and sells it to another person by adding some profit or mark-up
thereon.
2. The profit in murabahah can be determined by mutual
consent, either in lump sum or through an agreed ratio of profit to
be charged over the cost.
3. All the expenses incurred by the seller in acquiring the
commodity like freight, custom duty etc. shall be included in the
cost price and the mark-up can be applied on the aggregate cost.
However, recurring expenses of the business like salaries of the staff,
the rent of the premises etc. cannot be included in the cost of an
individual transaction. In fact, the profit claimed over the cost takes
care of these expenses.
4. Murabahah is valid only where the exact cost of a commodity
can be ascertained. If the exact cost cannot be ascertained, the
commodity cannot be sold on murabahah basis. In this case the
commodity must be sold on musawamah (bargaining) basis i.e.
71
AN INTRODUCTION TO ISLAMIC FINANCE
without any reference to the cost or to the ratio of profit / mark-up.
The price of the commodity in such cases shall be determined in
lump sum by mutual consent.
Example (1) A purchased a pair of shoes for Rs. 100/-. He wants
to sell it on murabahah with 10% mark-up. The exact cost is
known. The murabahah sale is valid.
Example (2) A purchased a ready - made suit with a pair of
shoes in a single transaction, for a lump sum price of Rs. 500/-.
A can sell the suit including shoes on murabahah. But he cannot
sell the shoes separately on murabahah, because the individual
cost of the shoes is unknown. If he wants to sell the shoes
separately, he must sell it at a lump sum price without reference
to the cost or to the mark-up.
Murabahah as a Mode of Financing
Originally, murabahah is a particular type of sale and not a mode of
financing. The ideal mode of financing according to Shari'ah is
mudarabah or musharakah which have been discussed in the first
chapter. However, in the perspective of the current economic set
up, there are certain practical difficulties in u sing mudarabah and
musharakah instruments in some areas of [=~jncing. Therefore, the
contemporary Shari'ah experts have allowed, subject to certain
conditions, the use of the murabahah on deferred payment basis as a
mode of financing. But there are two essential points which must be
fully understood in this respect:
1. It should never be overlooked that, originally, murabahah is
not a mode of financing. It is only a device to escape from "interest"
and not an ideal instrument for carrying out the real economic
objectives of Islam. Therefore, this instrument should be used as a
transitory step taken in the process of the Islamization of the
economy, and its use should be restricted only to those cases where
mudarabah or musharakah are not practicable.
2. The second important point is that the murabahah
transaction does not come into existence by merely replacing the
word of "interest" by the words of "profit" or "mark-up". Actually,
murabahah as a mode of finance, has been allowed by the Shari'ah
scholars with some conditions. Unless these conditions are fully
72
MURABAHAH
observed, murabahah is not permissible. In fact, it is the observance
of these conditions which can draw a clear line of distinction
between an interest-bearing loan and a transaction of murabahah. If
these conditions are neglected, the transaction becomes invalid
according to Shari'ah.
Basic Features of Murabahah Financing
1. Murabahah is not a loan given on interest. It is the sale of a
commodity for a deferred price which includes an agreed profit
added to the cost.
2. Being a sale, and not a loan, the murabahah should fulfil all
the conditions necessary for a valid sale, especially those enumerated
earlier in this chapter.
3. Murabahah cannot be used as a mode of financing except
where the client needs funds to actually purchase some
commodities. For example, if he wants funds to purchase cotton as
a raw material for his ginning factory, the Bank can sell him the
cotton on the basis of murabahah. But where the funds are required
for some other purposes, like paying the price of commodities
already purchased by him, or the bills of electricity or other utilities
or for paying the salaries of his staff, murabahah cannot be effected,
because murabahah requires a real sale of some commodities, and
not merely advancing a loan.
4. The financier must have owned the commodity before he
sells it to his client.
5. The commodity must come into the possession of the
financier, whether physical or constructive, in the sense that the
commodity must be in his risk, though for a short period.
6. The best way for murabahah, according to Shari'ah, is that
the financier himself purchases the commodity and keeps it in his
own possession, or purchases the commodity through a third person
appointed by him as agent, before he sells it to the customer.
However, in exceptional cases, where direct purchase from the
supplier is not practicable for some reason, it is also allowed that he
makes the customer himself his agent to buy the commodity on his
behalf. In this case the client first purchases the commodity on
behalf of his financier and takes its possession as such. Thereafter,
he purchases the commodity from the financier for a deferred price.
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AN INTRODUCTION TO ISLAMIC FINANCE
His possession over the commodity in the first instance is in the
capacity of an agent of his financier. In this capacity he is only a
trustee, while the ownership vests in the financier and the risk of the
commodity is also borne by him as a logical consequence of the
ownership. But when the client purchases the commodity from his
financier, the ownership, as well as the risk, is transferred to the
client.
7. As mentioned earlier, the sale cannot take place unless the
commodity comes into the possession of the seller, but the seller can
promise to sell even when the commodity is not in his possession.
The same rule is applicable to murabahah.
8. In the light of the aforementioned principles, a financial
institution can use the murabahah as a mode of finance by adopting
the following procedure:
Firstly: The client and the institution sign an over-all agreement
whereby the institution promises to sell and the client promises
to buy the commodities from time to time on an agreed ratio of
profit added to the cost. This agreement may specify the limit
upto which the facility may be availed.
Secondly: When a specific commodity is required by the
customer, the institution appoints the client as his agent for
purchasing the commodity on its behalf, and an agreement of
agency is signed by both the parties.
Thirdly: The client purchases the commodity on behalf of the
institution and takes its possession as an agent of the institution.
Fourthly: The client informs the institution that he has
purchased the commodity on his behalf, and at the same time,
makes an offer to purchase it from the institution.
Fifthly: The institution accepts the offer and the sale is
concluded whereby the ownership as well as the risk of the
commodity is transferred to the client.
All these five stages are necessary to effect a valid murabahah. If
the institution purchases the commodity directly from the supplier
(which is preferable) it does not need any agency agreement. In this
case, the second phase will be dropped and at the third stage the
institution itself will purchase the commodity from the supplier,
74
MURABAHAH
and the fourth phase will be restricted to making an offer by the
client.
The most essential element of the transaction is that the
commodity must remain in the risk of the institution during the
period between the third and the fifth stage. This is the only feature
of murabahah which can distinguish it from an interest-based
transaction. Therefore, it must be observed with due diligence at all
costs, otherwise the murabahah transaction becomes invalid
according to Shari'ah.
9. It is also a necessary condition for the validity of murabahah
that the commodity is purchased from a third party. The purchase
of the commodity from the client himself on 'buy back' agreement
is not allowed in Shari'ah. Thus murabahah based on 'buy back'
agreement is nothing more than an interest based transaction.
10. The above mentioned procedure of the murabahah
financing is a complex transaction where the parties involved have
different capacities at different stages.
(a) At the first stage, the institution and the client promise to
sell and purchase a commodity in future. This is not an actual sale.
It is just a promise to effect a sale in future on murabahah basis.
Thus at this stage the relation between the institution and the client
is that of a promisor and a promise.
(b) At the second stage, the relation between the parties is that
of a principal and an agent.
(c) At the third stage, the relation between the institution and
the supplier is that of a buyer and seller.
(d) At the fourth and fifth stage, the relation of buyer and seller
comes into operation between the institution and the client, and
since the sale is effected on deferred payment basis, the relation of a
debtor and creditor also emerges between them simultaneously.
All these capacities must be kept in mind and must come into
operation with all their consequential effects, each at its relevant
stage, and these different capacities should never be mixed up or
confused with each other.
1 1 . The institution may ask the client to furnish a security to its
satisfaction for the prompt payment of the deferred price. He may
also ask him to sign a promissory note or a bill of exchange, but it
must be after the actual sale takes place, i.e. at the fifth stage
mentioned above. The reason is that the promissory note is signed
75
AN INTRODUCTION TO ISLAMIC FINANCE
by a debtor in favour of his creditor, but the relation of debtor and
creditor between the institution and the client begins only at the
fifth stage, whereupon the actual sale takes place between them.
12. In the case of default by the buyer in the payment of price at
the due date, the price cannot be increased. However, if he has
undertaken, in the agreement to pay an amount for a charitable
purpose, as mentioned in para 7 of the rules of Bai' Mu'ajjal, he
shall be liable to pay the amount undertaken by him. But the
amount so recovered from the buyer shall not form part of the
income of the seller / the financier. He is bound to spend it for a
charitable purpose on behalf of the buyer, as will be explained later
in detail.
Some Issues Involved in Murabahah
So far the basic concept of murabahah has been explained. Now, it
is proposed to discuss some relevant issues with reference to the
underlying Islamic principles and their practical applicability in
murabahah transaction, because without correct understanding of
these issues, the concept may remain ambiguous and its practical
application may be susceptible to errors and misconceptions.
Different Pricing for Cash and Credit Sales
The first and foremost question about murabahah is that, when
used as a mode of financing, it is always effected on the basis of
deferred payment. The financier purchases the commodity on cash
payment and sells it to the client on credit. While selling the
commodity on credit, he takes into account the period in which the
price is to be paid by the client and increases the price accordingly.
The longer the maturity of the murabahah payment, the higher the
price. Therefore the price in a murabahah transaction, as practiced
by the Islamic banks, is always higher than the market price. If the
client is able to purchase the same commodity from the market on
cash payment, he will have to pay much less than he has to pay in a
murabahah transaction on deferred payment basis. The question
arises as to whether the price of a commodity in a credit sale may be
increased from the price of a cash sale. Some people argue that the
increase of price in a credit sale, being in consideration of the time
given to the purchaser, should be treated analogous to the interest
76
MURABAHAH
charged on a loan, because in both cases an additional amount is
charged for the deferment of payment. On this basis they argue that
the murabahah transactions, as practiced in the Islamic banks, are
not different in essence from the interest-based loans advanced by
the conventional banks.
This argument, which seems to be logical in appearance, is
based on a misunderstanding about the principles of Shari'ah
regarding the prohibition of riba. For the correct comprehension of
the concept the following points must be kept in view.
The modern capitalist theory does not differentiate between
money and commodity in so far as commercial transactions are
concerned. In the matter of exchange, money and commodity both
are treated at par. Both can be traded in. Both can be sold at
whatever price the parties agree upon. One can sell one dollar for
two dollars on the spot as well as on credit, just as he can sell a
commodity valuing one dollar for two dollars. The only condition is
that it should be with mutual consent.
The Islamic principles, however, do not subscribe to this theory.
According to Islamic principles, money and commodity have
different characteristics and therefore, they are treated differently.
The basic points of difference between money and commodity are
the following:
(a) Money has no intrinsic utility. It cannot be utilized for
fulfilling human needs directly. It can only be used for acquiring
some goods or services. The commodities, on the other hand, have
intrinsic utility. They can be utilized directly without exchanging
them for some other thing.
(b) The commodities can be of different qualities, while money
has no quality except that it is a measure of value or a medium of
exchange. Therefore, all the units of money, of same denomination,
are 100% equal to each other. An old and dirty note of Rs. 1000/-
has the same value as a brand new note of Rs. 1000/-, unlike the
commodities which may have different qualities, and obviously an
old and used car may be much less in value than a brand new car.
(c) In commodities, the transaction of sale and purchase is
effected on a particular individual commodity or, at least, on the
commodities having particular specifications. If A has purchased a
particular car by pin-pointing it and seller has agreed, he deserves to
receive the same car. The seller cannot compel him to take the
77
AN INTRODUCTION TO ISLAMIC FINANCE
delivery of another car, though of the same type or quality. This can
only be done if the purchaser agrees to it which implies that the
earlier transaction is cancelled and a new transaction on the new car
is effected by mutual consent.
Money, on the contrary, cannot be pin-pointed in a transaction
of exchange. If A has purchased a commodity from B by showing
him a particular note of Rs. 1000/- he can still pay him another
note of the same denomination, while B cannot insist that he will
take the same note as was shown to him.
Keeping these differences in view, Islam has treated money and
commodities differently. Since money has no intrinsic utility, but is
only a medium of exchange which has no different qualities, the
exchange of a unit of money for another unit of the same
denomination cannot be effected except at par value. If a currency
note of Rs. 1000/- is exchanged for another note of Pakistani
Rupees, it must be of the value of Rs. 1000/- The price of the
former note can neither be increased nor decreased from Rs. 1000/-
even in a spot transaction, because the currency note has no
intrinsic utility nor a different quality (recognized legally), therefore
any excess on either side is without consideration, hence not
allowed in Shari'ah. As this is true in a spot exchange transaction, it
is also true in a credit transaction where there is money on both
sides, because if some excess is claimed in a credit transaction
(where money is exchanged for money) it will be against nothing
but time.
The case of the normal commodities is different. Since they
have intrinsic utility and have different qualities, the owner is at
liberty to sell them at whatever price he wants, subject to the forces
of supply and demand. If the seller does not commit a fraud or
misrepresentation, he can sell a commodity at a price higher than
the market rate with the consent of the purchaser. If the purchaser
accepts to buy it at that increased price, the excess charged from
him is quite permissible for the seller. When he can sell his
commodity at a higher price in a cash transaction, he can also
charge a higher price in a credit sale, subject only to the condition
that he neither deceives the purchaser, nor compels him to
purchase, and the buyer agrees to pay the price with his free will.
It is sometimes argued that the increase of price in a cash
transaction is not based on the deferred payment, therefore it is
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MURABAHAH
permissible while in a sale based on deferred payment, the increase
is purely against time which makes it analogous to interest. This
argument is again based on the misconception that whenever price
is increased taking the time of payment into consideration, the
transaction comes within the ambit of interest. This presumption is
not correct. Any excess amount charged against late payment is riba
only where the subject matter is money on both sides. But if a
commodity is sold in exchange of money, the seller, when fixing the
price, may take into consideration different factors, including the
time of payment. A seller, being the owner of a commodity which
has intrinsic utility may charge a higher price and the purchaser may
agree to pay it due to various reasons, for example:
(a) His shop is nearer to the buyer who does not want to go
to the market which is not so near.
(b) The seller is more trust- worthy for the purchaser than
others, and the purchaser has more confidence in
him that he will give him the required thing without
any defect.
(c) The seller gives him priority in selling commodities
having more demand.
(d) The atmosphere of the shop of the seller is cleaner and
more comfortable than other shops,
(e) The seller is more courteous in his dealings than others.
These and similar other considerations play their role in
charging a higher price from the customer. In the same way, if a
seller increases the price because he allows credit to his client, it is
not prohibited by Shari'ah if there is no cheating and the purchaser
accepts it with open eyes, because whatever the reason of increase,
the whole price is against a commodity and not against money. It is
true that, while increasing the price of the commodity, the seller has
kept in view the time of its payment, but once the price is fixed, it
relates to the commodity, and not to the time. That is why if the
purchaser fails to pay at the stipulated time, the price will remain
the same and can never be increased by the seller. Had it been
against time, it might have been increased, if the seller allows him
more time after the maturity.
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AN INTRODUCTION TO ISLAMIC FINANCE
To put it another way, since money can only be traded in at par
value, as explained earlier, any excess claimed in a credit transaction
(of money in exchange of money) is against nothing but time. That
is why if the debtor is allowed more time at maturity, some more
money is claimed from him. Conversely, in a credit sale of a
commodity, time is not the exclusive consideration while fixing the
price. The price is fixed for commodity, not for time. However,
time may act as an ancillary factor to determine the price of the
commodity, like any other factor from those mentioned above, but
once this factor has played its role, every part of the price is
attributed to the commodity.
The upshot of this discussion is that when money is exchanged
for money, no excess is allowed, neither in cash transaction, nor in
credit, but where a commodity is sold for money, the price agreed
upon by the parties may be higher than the market price, both in
cash and credit transactions. Time of payment may act as an
ancillary factor to determine the price of a commodity, but it
cannot act as an exclusive basis for and the sole consideration of an
excess claimed in exchange of money for money.
This position is accepted unanimously by all the four schools of
Islamic law and the majority of the Muslim jurists. They say that if
a seller determines two different prices for cash and credit sales, the
price of the credit sale being higher than the cash price, it is allowed
in Shari'ah. The only condition is that at the time of actual sale, one
of the two options must be determined, leaving no ambiguity in the
nature of the transaction. For example, it is allowed for the seller, at
the time of bargaining, to say to purchaser, "If you purchase the
commodity on cash payment, the price would be Rs. 100/- and if
you purchase it on a credit of six months, the price would be Rs.
110/-." But the purchaser shall have to select either of the two
options. He should say that he would purchase it on credit for Rs.
110/-. Thus, at the time of actual sale, the price will be known to
both parties. 2
However, if either of the two options is not determined in
specific terms, the sale will not be valid. This may happen in those
installment sales in which different prices are claimed for different
2 See Ibn Qudamah, al-Mughni, 4:290; al-Sarakhsi, al-Mabsut, 13:8; al-Dasuqi,
3 : 5 8 ; and Mughni al-Muhtaj, 2:31.
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MURABAHAH
maturities. In this case the seller draws a schedule of prices
according to schedule of payment. For example, Rs. 1000/- are
charged for the credit of 3 months Rs. 1100/- for the credit of 6
months, Rs. 1200/- for 9 month and so on. The purchaser takes the
commodity without specifying the option he will exercise, on the
assumption that he will pay the price in future according to his
convenience. This transaction is not valid, because the time of
payment, as well as the price, is not determined. But if he chooses
one of this options specifically and says, for example, that he
purchases the commodity on 6 months credit with a price of 1 100/-
the sale will be valid.
Another point must be noted here. What has been allowed
above is that the price of the commodity in a credit sale is fixed at
more than the cash price. But if the sale has taken place at cash
price, and the seller has imposed a condition that in case of late
payment, he will charge 10% per annum as a penalty or as interest,
this is totally prohibited; because what is being charged is not a part
of the price; it is an interest charged on a debt.
The practical difference between the two situations is that where
the additional amount is a part of the price, it may be charged on a
one time basis only. If the purchaser fails to pay it on time, the seller
cannot charge another additional amount. The price will remain the
same without any addition. Conversely, where the additional
amount is not a part of the price it will keep increasing with the
period of default.
The Use of Interest-Rate as Benchmark
Many institutions financing by way of murabahah determine their
profit or mark-up on the basis of the current interest rate, mostly
using LIBOR (Inter-bank offered rate in London) as the criterion.
For example, if LIBOR is 6%, they determine their mark-up on
murabahah equal to LIBOR or some percentage above LIBOR.
This practice is often criticized on the ground that profit based on a
rate of interest should be as prohibited as interest itself.
No doubt, the use of the rate of interest for determining a halal
profit cannot be considered desirable. It certainly makes the
transaction resemble an interest-based financing, at least in
appearance, and keeping in view the severity of prohibition of
AN INTRODUCTION TO ISLAMIC FINANCE
interest, even this apparent resemblance should be avoided as far a
possible. But one should not ignore the fact that the most
important requirement for validity of murabahah is that it is a
genuine sale with all its ingredients and necessary consequences. If a
murabahah transaction fulfils all the conditions enumerated in this
chapter, merely using the interest rate as a benchmark for
determining the profit of murabahah does not render the
transaction as invalid, haram or prohibited, because the deal itself
does not contain interest. The rate of interest has been used only as
an indicator or as a benchmark. In order to explain the point, let me
give an example.
A and B are two brothers. A trades in liquor which is totally
prohibited in Shari'ah. B, being a practicing Muslim dislikes the
business of A and starts the business of soft drinks, but he wants his
business to earn as much profit as A earns through trading in liquor,
therefore he resolves that he will charge the same rate of profit from
his customers as A charges over the sale of liquor. Thus he has tied
up his rate of profit with the rate used by A in his prohibited
business. One may question the propriety of his approach in
determining the rate of his profit, but obviously no one can say that
the profit charged by him in his halal business is haram, because he
has used the rate of profit of the business of liquor as a benchmark.
Similarly, so far as the transaction of murabahah is based on
Islamic principles and fulfils all its necessary requirements, the rate
of profit determined on the basis of the rate of interest will not
render the transaction as haram.
It is, however true that the Islamic banks and financial
institutions should get rid of this practice as soon as possible,
because, firstly, it takes the rate of interest as an ideal for a halal
business which is not desirable, and secondly because it does not
advance the basic philosophy of Islamic economy having no impact
on the system of distribution. Therefore, the Islamic banks and
financial institutions should strive for developing their own
benchmark. This can be done by creating their own inter-bank
market based on Islamic principles. The purpose can be achieved by
creating a common pool which invests in asset-backed instruments
like musharakah, ijarah etc. If majority of the assets of the pool is in
tangible form, like leased property or equipment, shares in business
concerns etc. its units can be sold and purchased on the basis of
82
MURABAHAH
their net asset value determined on periodical basis. These units may
be negotiable and may be used for overnight financing as well. The
banks having surplus liquidity can purchase these units and when
they need liquidity, they can sell them. This arrangement may
create inter-bank market and the value of the units may serve as an
indicator for determining the profit in murabahah and leasing also
Promise to Purchase
Another important issue in murabahah financing which has been
subject of debate between the contemporary Shari'ah Scholars is
that the bank/financier cannot enter into an actual sale at the time
when the client seeks murabahah financing from him, because the
required commodity is not owned by the bank at this stage and, as
explained earlier, one cannot sell a commodity not owned by him,
nor can he effect a forward sale. He is, therefore, bound to purchase
the commodity from the supplier, then he can sell it to the client
after having its physical or constructive possession. On the other
hand, if the client is not bound to purchase the commodity after the
financier has purchased it from the supplier, the financier may be
confronted with a situation where he has incurred huge expenses to
acquire the commodity, but the client refuses to purchase it. The
commodity may be of such a nature that it has no common demand
in the market and is very difficult to dispose of. In this case the
financier may suffer unbearable loss.
Solution to this problem is sought in the murabahah
arrangement by asking the client to sign a promise to purchase the
commodity when it is acquired by the financier. Instead of being a
bilateral contract of forward sale, it is a unilateral promise from the
client which binds himself and not the financier. Being a one-sided
promise, it is distinguishable from the bilateral forward contract.
This solution is subjected to the objection that a unilateral
promise creates a moral obligation but it cannot be enforced,
according to Shari'ah, by the courts of law. This leads us to the
question whether or not a one-sided promise is enforceable in
Shari'ah. The general impression is that it is not, but before
accepting this impression at its face value, we will have to examine it
in the light of the original sources of Shari'ah.
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AN INTRODUCTION TO ISLAMIC FINANCE
A thorough study of the relevant material in the books of
Islamic jurisprudence would show that the fuqaha' (the Muslim
jurists) have different views on the subject. Their views may be
summarized as follows:
1. Many of them are of the opinion that 'fulfilling a promise' is
a noble quality and it is advisable for the promisor to observe it, and
its violation is reproachable, but it is neither mandatory (wajib), nor
enforceable through courts. This view is attributed to Imam Abu
Hanifah, Imam al-Shafi'i, Imam Ahmad and to some Maliki
jurists. 3 However as will be shown later, many Hanafi and Maliki
and some Shafi'i' jurists do not subscribe to this view.
2. A number of the Muslim jurists are of the view that fulfilling
a promise is mandatory and a promisor is under moral as well as
legal obligation to fulfil his promise. According to them, promise
can be enforced through courts of law. This view is ascribed to
Samurah ibn Jundub ife the well known companion of the Holy
Prophet Hi, Umar ibn Abd al-Aziz, Hasan al-Basri, Sa'id ibn al-
Ashwa', Ishaq ibn Rahwaih and Imam al-Bukhari. The same is the
view of some Maliki jurists, and it is preferred by Ibn al- Arabi and
Ibn al-Shat, and endorsed by al-Ghazzali, the famous Shafi'i jurist,
who says the promise is binding, if it is made in absolute terms. The
same is the view of Ibn Shubrumah. 5 The third view is presented by
some Maliki jurists. They say that in normal conditions, promise is
not binding, but if the promisor has caused the promise to incur
some expenses or undertake some labor or liability on the basis of
promise, it is mandatory on him to fulfil his promise for which he
may be compelled by the courts. 6
Some contemporary scholars have claimed that the jurists who
have accepted the binding nature of a promise have done so only
with regard to unilateral gifts or other voluntary payments, but
3 See Umdat al-Qari, 12:121; Mirqat al-Mafatih, 4:653; al-Adhkar al-Nawawi,
282; Fat-h al-'Ali al-Malik, 1:254.
4 See Sahih al-Bukhari, Kitab al-Shahadat, where this view is reported from the all
the aforesaid jurists.
5 Al-Qurtubi, Al-Jami' li-Ahkam al-Qur'an, 18:29; Hashiyah ibn al-Shat 'ala
Furuq al-Qarafi, 4:24; Al-Ghazzali, Ihya Ulum al-Din, 3:133; Ibn Hazm, al-
Muhalla, 8:28.
6 Al-Furuq al-Qarafi, 4:25; Fat-h ai-'AJi al-Malik, 1:254.
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MURABAHAH
none of them has accepted the binding nature of a promise to effect
a bilateral commercial or monetary transaction. However, based on
a close study, this notion does not seem to be correct, because the
Maliki and Hanafi jurists have allowed ' Bai' bil wafa on the basis of
binding promise. Bai' bil wafa' is a special kind of sale whereby the
purchaser of an immovable property undertakes that whenever the
seller will give him the price back, he will resell the house to him.
The question of validity of 'Bai'bil wafa' has already been discussed
in detail in the first chapter while explaining the concept of house
financing on the basis of 'diminishing musharakah'. The gist of the
discussion is that if repurchase by the seller is made a condition for
the original sale, it is not a valid transaction, but if the parties have
entered into the original sale unconditionally, but the seller has
signed a separate and independent promise to repurchase the sold
property, this promise will be binding on the promisor and
enforceable through the courts. The binding nature of the promise
in this case has been admitted by both Maliki and Hanafi jurists. 7
Obviously, this promise does not relate to a gift. It is a promise
to effect a sale in future. Still, the Maliki and Hanafi jurists have
accepted it as binding on the promisor and enforceable through the
courts. It is a clear proof of the fact that the jurists who hold the
promises to be binding do not restrict it to the promises of gifts etc.
The same principle is applicable, according to them, to the promises
whereby the promisor undertakes to enter into a bilateral contract
in future.
In fact, the Holy Qur'an and the Sunnah of the Holy Prophet
JH are very particular about fulfilling promises. The Holy Qur'an
says:
And fulfill the covenant. Surely, the covenant will be asked about
(in the Hereafter) (Bani Isra'il: 34)
Al-Hattab, TahrJr al-Kalam (Beirut, 1404 AH), 239.
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AN INTRODUCTION TO ISLAMIC FINANCE
(d- c ^oio^jL^^uy^oi
O those who believe, why do you say what you not do. It invites
Allah's anger that you say what you not do. (al-Saf:2 to 3)
Imam Abu Bakr al-Jassas has said that this verse of the Holy
Qur'an indicates that if one undertakes to do something, no matter
whether it is a worship or a contract, it is obligatory on him to do
it. 8
The Holy Prophet <H is reported to have said:
There are three distinguishing features of a hypocrite: when he
speaks, tells a lie, when he promises, he backs out and when he is
given something in trust, he breaches the trust. 9
This is only an example. There is a large number of injunctions
in the ahadith of the Holy Prophet 3|| where it is ordained to fulfil
the promises and it is clearly prohibited to back out, except for a
valid reason.
Therefore, it is evident from these injunctions that fulfilling
promise is obligatory. However, the question whether or not a
promise is enforceable in courts depends on the nature of the
promise. There are certainly some sorts of promises which cannot
be enforced through courts. For example, at the time of engagement
the parties promise to go through the marriage. These promises
create a moral obligation, but obviously they cannot be enforced
through courts of law. But in commercial dealings, where a party
has given an absolute promise to sell or purchase something and the
other party has incurred liabilities on that basis, there is no reason
why such a promise should not be enforced. Therefore, on the basis
of the clear injunctions of Islam, if the parties have agreed that this
8 Al-Jassas, Ahkam al-Qur'an, 3:420.
9 Sahih al-Bukhari, Kitab al-Iman.
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MURABAHAH
particular promise will be binding on the promisor, it will be
enforceable.
This is not a question pertaining to murabahah alone. If
promises are not enforceable in the commercial transactions, it may
seriously jeopardize commercial activities. If somebody orders a
trader to bring for him a certain commodity and promises to
purchase it from him, on the basis of which the trader imports it
from abroad by incurring huge expenses, how can it be allowed for
the former to refuse to purchase it? There is nothing in the Holy
Qur'an or Sunnah which prohibits the making of such promises
enforceable.
It is on these grounds that the Islamic Fiqh Academy Jeddah has
made the promises in commercial dealings binding on the promisor
with the following conditions,
(a) It should be one-sided promise.
(b) The promise must have caused the promise to incur some
liabilities.
(c) If the promise is to purchase something, the actual sale must
take place at the appointed time by the exchange of offer
and acceptance. Mere promise itself should not be taken as
the concluded sale.
(d) If the promisor backs out of his promise, the court may
force him either to purchase the commodity or pay actual
damages to the seller. The actual damages will include the
actual monetary loss suffered by him, but will not include
the opportunity cost.
On this basis, it is allowed that the client promises to the
financier that he will purchase the commodity after the latter
acquires it from the supplier. This promise will be binding on him
and may be enforced through courts in the manner explained above.
This promise does not amount to actual sale. It will be simply a
promise and the actual sale will take place after the commodity is
acquired by the financier for which exchange of offer and
acceptance will be necessary.
10 Resolution no. 2 and 3, Fifth Confetence of the Islamic Fiqh Academy held in
Kuwait, 1409 AH. See the academy's journal no. 5, 2:1599.
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AN INTRODUCTION TO ISLAMIC FINANCE
Securities against Murabahah Price
Another issue regarding murabahah financing is that the murabahah
price is payable at a later date. The seller/financier naturally wants
to make sure that the price will be paid at the due date, for this
purpose, he may ask the client to furnish a security to his
satisfaction. The security may be in the form of a mortgage or a
hypothecation or some kind of lien or charge. Some basic rules
about this security must, therefore, be kept in mind.
1 . The security can be claimed rightfully where the transaction
has created a liability or a debt. No security can be asked from a
person who has not incurred a liability or debt. As explained earlier,
the procedure of murabahah financing comprises of different
transactions carried out at different stages. In the earlier stages of the
procedure, the client does not incur a debt. It is only after the
commodity is sold to him by the financier on credit that the
relationship of a creditor and debtor comes into existence.
Therefore, the proper way in a transaction of murabahah would be
that the financier asks for a security after he has actually sold the
commodity to the client and the price has become due on him,
because at this stage the client incurs a debt. However, it is also
permissible that the client furnishes a security at earlier stages, but
after the murabahah price is determined. In this case, if the security
is possessed by the financier, it will remain at his risk, meaning
thereby that if it is destroyed before the actual sale to the client, he
will have either to pay the market price of the mortgaged asset, and
cancel the agreement of murabahah, or sell the commodity required
by the client and deduct the market price of the mortgaged asset
from the price of the sold property. n
2. It is also permissible that the sold commodity itself is given to
the seller as a security. Some scholars are of the opinion that this can
only be done after the purchaser has taken its delivery and not
before. It means that the purchaser shall take its delivery, either
physical or constructive, from the seller, then give it back to him as
mortgage, so that the transaction of mortgage is distinguished from
11 Ibn Nujaym writes,
(©1398:450 ^sA^^mjDi^^k^<^d^MlyL0 L Xk
88
MURABAHAH
the transaction of sale. However, after studying the relevant
material, it can be concluded that the earlier jurists have put this
condition in cash sales only and not in credit sales.
Therefore, it is not necessary that the purchaser takes the
delivery of the sold property before he surrenders it as mortgage to
the seller. The only requirement would be that the point of time
whereby the property is held to be mortgaged should necessarily be
specified, because from that point of time, the property will be held
by the seller in a different capacity which should be clearly
earmarked. For example, A sold a car to B on first of January for a
price of Rs. 500,000/- to be paid on 30th June. A asked B to give a
security for payment at the due date. B has not yet taken delivery of
the car and he offered to A that he should keep the car as a
mortgage from 2nd January. If the car is destroyed before 2nd of
January the sale will be terminated and nothing will be payable by
B. But if the car is destroyed after the second of January, sale is not
terminated, but it will be subject to the rules prescribed for the
destruction of a mortgage. According to Hanafi jurists, in this case,
the seller will have to bear the loss of the car, to the extent of its
market price or its agreed sale price, whichever is lesser. Therefore, if
the market price of the car was 450,000/- he can claim only the
remaining part of the agreed sale price (i.e. Rs. 50,000/- in the
above example). If the market price of the car is Rs. 500,000/- or
higher, nothing can be claimed from the purchaser.
This is the view of Hanafi School. The Shafi'i and Hanbali
jurists hold that if the car is destroyed by the negligence of the
mortgagee, he will have to bear the loss, according to its market
price, but if the car is destroyed without any fault on his part, he
will not be liable to anything, and the purchaser will bear the loss
and will have to pay the full price. 13
It is clear from the above example that the possession of A over
the car as a seller carries effects and consequences different from his
possession as a mortgagee and therefore it is necessary that the point
of time on which the car is held by him as a mortgagee should
12 The detailed discussion on the subject may be found in the revised edition of
my Arabic book "Q^/M)^M?Z Q $11
13 See Ibn Qudamah, Al-Mughni, 4:442; al-Ghazzali, al-Wask, 3:509; Ibn
'Abidin, Radd al-Muhtar, 5:341.
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AN INTRODUCTION TO ISLAMIC FINANCE
clearly be defined. Otherwise different capacities will be mixed up
giving rise to dispute and rendering the security invalid.
Guaranteeing the Murabahah
The seller in a murabahah financing can also ask the
purchaser/ client to furnish a guarantee from a third party. In case of
default in the payment of price at the due date, the seller may have
recourse to the guarantor, who will be liable to pay the amount
guaranteed by him. The rules of Shari'ah regarding guarantee are
fully discussed in the books of Islamic fiqh. However, I would point
out to two burning issues in the context of Islamic banking.
The guarantor in the contemporary commercial atmosphere
does not normally guarantee a payment without a fee charged from
the original debtor. The classical Fiqh literature is almost
unanimous on the point that the guarantee is a voluntary
transaction and no fee can be charged on a guarantee. The most the
guarantor can do is to claim his actual secretarial expenses incurred
in offering the guarantee, but the guarantee itself should be free of
charge. The reason for this prohibition is that the person who
advances money to another person as a loan cannot charge a fee for
advancing a loan, because it falls under the definition of riba or
interest which is prohibited. The guarantor should be subject to this
prohibition all the more, because he does not advance money. He
only undertakes to pay a certain amount on behalf of the original
debtor in case he defaults in payment. If the person who actually
pays money cannot charge a fee, how can fee be charged by a person
who has merely undertaken to pay and did not pay anything in
actual terms?
Suppose, A has borrowed 100 US dollars from B who asked
him to produce a guarantor. C says to A, "I pay off your debt to B
right now, but you will have to pay me 110 dollars at a later date."
Obviously 10 dollars charged from A are not allowed, being
interest. Then D comes to A and says, "I stand as a guarantor to
you, but you will have to pay me 10 dollars for this service." If we
allow to charge a fee for guarantee, it will mean that C cannot
charge 10 dollars, despite the fact that he has actually paid the
amount, and D can charge 10 dollars, despite the fact that he has
merely committed himself to pay only when A fails to pay. This
90
MURABAHAH
being unfair apparently, the classical Muslim jurists have forbidden
the charging of a fee for guarantee, so that both C and D, in the
above example, may stand on equal footing.
However, some contemporary scholars are considering the
problem from a different angle. They feel that guarantee has
become a necessity, especially in international trade where the sellers
and the buyers do not know each other, and the payment of the
price by the purchaser cannot be simultaneous with the supply of
the goods. There has to be an intermediary who can guarantee the
payment. It is utterly difficult to find the guarantors who can
provide this service free of charge in required numbers. Keeping
these realities in view, some Shari'ah scholars of our time are
adopting a different approach. They say that the prohibition of
guarantee fee is not based on any specific injunction of the Holy
Qur'an or the Sunnah of the Holy Prophet #||. It has been deduced
from the prohibition of riba as one of its ancillary consequences.
Moreover, guarantees in the past were of simple nature. In today's
commercial activities, the guarantor sometimes needs a number of
studies and a lot of secretarial work. Therefore, they opine, the
prohibition of the guarantee fee should be reviewed in this
perspective. The question still needs further research and should be
placed before a larger forum of scholars. However, unless a definite
ruling is given by such a forum, no guarantee fee should be charged
or paid by an Islamic financial institution. Instead, they can charge
or pay a fee to cover expenses incurred in the process of issuing a
guarantee.
Penalty of Default
Another problem in murabahah financing is that if the client
defaults in payment of the price at the due date, the price cannot be
increased. In interest-based loans, the amount of loan keeps on
increasing according to the period of default. But in murabahah
financing, once the price is fixed, it cannot be increased. This
restriction is sometimes exploited by dishonest clients who
deliberately avoid to pay the price at its due date, because they know
that they will not have to pay any additional amount on account of
default.
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AN INTRODUCTION TO ISLAMIC FINANCE
This characteristic of murabahah should not create a big
problem in a country where all the banks and financial institutions
are run on Islamic principles, because the government or the central
bank may develop a system where such defaultors may be penalized
by depriving them from obtaining any facility from any financial
institution. This system may serve a a deterrent against deliberate
defaults. However, in the countries where the Islamic banks and
financial institutions are working in isolation from the majority of
financial institutions run on the basis of interest, this system can
hardly work, because even if the client is deprived to avail of a
facility from an Islamic bank, he can approach the conventional
institutions.
In order to solve this problem, some contemporary scholars
have suggested that the dishonest clients who default in payment
deliberately should be made liable to pay compensation to the
Islamic bank for the loss it may have suffered on account of default.
They suggest that the amount of this compensation may be equal to
the profit given by that bank to its depositors during the period of
default. For example, the defaulter has paid the price three months
after the due date. If the bank has given to its depositors a profit at
the rate of 5%, the client has to pay 5% more as compensation for
the loss of the bank. However, the scholars who allow this
compensation make it subject to the following conditions:
(a) The defaulter should be given a grace period of at least one
month after the maturity date during which he must be given
weekly notices warning him that he should pay the price, otherwise
he will have to pay compensation.
(b) It is proved beyond doubt that the client is defaulting
without valid excuse. If it appears that his default is due to poverty,
no compensation can be claimed from him. Indeed, he must be
given respite until he is able to pay, because the Holy Qur'an has
expressly said,
(cec :#8j^ ^t¥S>^i/i^fojj
And if he (the debtor) is short of funds, then he must be given
respite until he is well off. (2:280)
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MURABAHAH
(c) The compensation is allowed only if the investment account
of the Islamic bank has earned some profit to be distributed to the
depositors. If the investment account of the bank has not earned
profit during the period of default, no compensation shall be
claimed from the client.
This concept of compensation, however, is not accepted by the
majority of the present day scholars, (including the author). It is the
considered opinion of such scholars that this suggestion neither
conforms to the principles of Shari'ah nor is it able to solve the
problem of default.
First of all, any additional amount charged from a debtor is riba.
In the days of Jahiliyyah (before Islam) the people used to charge
additional amounts from their debtors when they were not able to
pay at the due date. They used to say,
Either you pay off the debt or you increase the payable amount.
The aforementioned suggestion of paying compensation to the
creditor/seller resembles the same attitude.
It can be argued that the above suggestion is theoretically
different from the practice of jahiliyyah in that the suggestion is to
grant the debtor a grace period of one month to make sure that he is
avoiding payment without a valid cause and to exempt him from
compensation if it appears that his non-payment is due to poverty
or a hardship. But in practical application of the concept, these
conditions are hardly fulfilled, because every debtor may claim that
his default is due to his financial inability at the due date, and it is
very difficult for a financial institution to hold an inquiry about the
financial position of each client and to verify whether or not he was
able to pay. What the banks normally do is that they presume that
every client was able to pay unless he has been declared as bankrupt
or insolvent. It means that the concession allowed in the suggestion
can be enjoyed only by the insolvent people. Obviously, insolvency
is a rare phenomenon, and in this rare situation, even the interest-
based banks cannot normally recover interest from the borrower.
Therefore, the suggestion leaves no practical and meaningful
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AN INTRODUCTION TO ISLAMIC FINANCE
difference between an interest based financing and an Islamic
financing.
So far as grace period is concerned, it is a minor concession
which is sometimes given by the conventional banks as well. Once
again, in practical terms, there is no material difference between
interest and the late payment charged as compensation.
It is argued in favor of charging compensation that the Holy
Prophet 5|§ has condemned the person who delays the payment of
his dues without a valid cause. According to the well-known hadith
he has said,
The well-off person who delays the payment of his debt, subjects
himself to punishment and disgrace.
The argument runs that the Holy Prophet <H has permitted to
inflict a punishment on such a person. The punishments may be of
different kinds, including the imposition of a monetary penalty. But
this argument overlooks the fact that even if it is assumed that
imposing fine or a monetary penalty is allowed in Shari'ah, 15 it is
imposed by a court of law and is normally paid to the government.
Nobody has allowed a situation where an aggrieved party imposes
the fine on its own (and for its own benefit) without a judgment of
a court, competent to decide the matter.
Moreover, had it been a recognized punishment, it should have
been imposed even if the investment account has earned no profit
during that period, because the guilt of the defaulter is established
and it has no nexus with the profit of the investment account of the
bank.
In fact, the suggestion of compensation equal to the rate of
profit of the investment account is based on the concept of
opportunity cost of money. This concept is foreign to the principles
of Shari'ah. Islam does not recognize opportunity cost of money,
14 Sahih al-Bukhari, hadith no. 2400, with Fath al-Bari, 5:62.
15 Many classical jurists do not allow the imposition of fine (JL^W jjj*j) even by a
court of law; however, some classical jurists, like Imam Ahmad and Abu Yusuf
allow it and this is the preferred view according to most contemporary jurists.
94
MURABAHAH
because after the elimination of interest from the economy, money
has no definite return. It is always exposed to loss as well as it has
the ability to earn a profit. And it is the risk of loss which makes it
entitled to gain a return.
Another point is worth attention. The one who defaults in
payment of debt is, at the most, like a thief or a usurper. But the
study of the rules prescribed for theft and usurpation would show
that a thief has been subjected to very severe punishment of
amputating his hands, but he was never asked to pay an additional
mount to compensate the victim of theft. Similarly, if a person has
usurped the money of another person, he may be punished by way
of ta'zir, but no Muslim jurist has ever imposed on him a financial
penalty to compensate the owner.
Imam al-Shafi'i is of the view that if someone usurps the land of
another person, he will have to pay the rent of the land according to
the market rate. But if he has usurped money, he will return the
equal amount of money and not more. 16
All these rules go a long way to prove that the opportunity cost
of money is never recognized by the Islamic Shari'ah, because, as
explained above, money has no definite return, nor any intrinsic
utility.
On the basis of what is stated above, the idea of compensation
to be charged from a defaulter is not approved by most of the
contemporary scholars. The question was thoroughly discussed in
the annual session of Islamic Fiqh Academy, Jeddah, and it was
resolved that no such compensation is allowed in Shari'ah. 17
All this discussion relates to the impermissibility of the proposed
compensation in Shari'ah. Now it is to be noted that this proposal
does not solve the problem of default at all. To the contrary, it may
encourage the debtors to commit as much default as they wish. The
reason is that, according to this suggestion, the defaulter is asked to
pay compensation equal to the return earned by the depositors
during the period of default. It is evident that the rate of return
earned by the depositors is always less than the rate of profit paid by
the customer in a murabahah transaction. Therefore, the customer
16 Al-Shirazi, al-Muhadh-dhab, 1:370.
17 Resolution no. 53, Vth Annual Session of the Islamic Fiqh Academy, Jeddah,
Journal no. 6, 1:447.
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AN INTRODUCTION TO ISLAMIC FINANCE
will be paying after default, much less than he was paying before the
default. Therefore, he would willingly accept to pay this amount
and not pay the amount of price which he will invest in a more
profitable activity. Suppose the rate of profit agreed in a murabahah
transaction of six moths is 15% p. a. and the rate of profit declared
to the depositors is 10%. p. a. It means that if the client withholds
the price of murabahah after its maturity date and keeps it for
another six months, he will have to pay the compensation at the rate
of 10% p. a. which is much less than the rate of original murabahah
(i.e. 15%). As such he will default and enjoy another facility for the
next six months at a lesser rate.
This proposal, therefore, is not only against Shari'ah, but also
deficient in meeting the problem of default.
The Alternative Suggestion
The question now arises as to how the banks and financial
institutions may solve this problem. If nothing is charged from the
defaulters, it may be a greater incentive for a dishonest person to
default continuously. Here is the answer to this question:
We have already mentioned that the real solution to this
problem is to develop a system where the defaulters are duly
punished by depriving them from enjoying a financial facility in
future. However, as commented earlier, this may be only where the
whole banking system is based on Islamic principles, or the Islamic
banks are given due protection against defaulters. Therefore, up to a
time when this goal is reached, we may need some other alternative.
For this purpose it was suggested that the client, when entering
into a murabahah transaction, should undertake that in case he
defaults in payment at the due date, he will pay a specified amount
to a charitable fund maintained by the bank. It must be ensured
that no part of this amount shall form part of the income of the
bank. However, the bank may establish a charitable fund for this
purpose and all amounts credited therein shall be exclusively used
for purely charitable purpose approved by the Shari'ah. The bank
may also advance interest-free loans to the needy persons from this
charitable fund.
This proposal is based on a ruling given by some Maliki jurists
who say that if a debtor is asked to pay an additional amount in case
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MURABAHAH
of default, it is not allowed by Shari'ah, because it amounts to
charging interest. However, in order to assure the creditor of
prompt payment, the debtor may undertake to give some amount in
charity in case of default. This is, in fact, a sort of Yamin (vow)
which is a self-imposed penalty to keep oneself away from default.
Normally, such 'vows' create a moral or religious obligation and are
not enforceable through courts. However, some Maliki jurists allow
to make it justiceable, and there is nothing in the Holy Qur'an or
in the Sunnah of the Holy Prophet j|§ which forbids making this
'vow' enforceable through the courts of law. Therefore, in cases of
genuine need, this view can be acted upon. But, while
implementing this proposal, the following points must be kept in
mind.
1. The proposal is meant only to pressurize the debtors on
paying their dues promptly and not to increase the income of the
creditor / financier, nor to compensate him for his opportunity cost.
Therefore, it must be ensured that no part of the penalty forms part
of the income of the bank in any case, nor can it be used to pay
taxes or to set-off any liability of the financier.
2. Since the amount of penalty is not deserved by the financier
as his income, but it goes to charity, it may be any amount willfully
undertaken by the debtor. It can also be determined on per cent per
annum basis. Therefore, it may serve as a real deterrent against
deliberate default, unlike the former suggestion of compensation
which, as explained earlier, may tend to encourage the defaults.
3. Since the penalty undertaken by the client is originally a self-
undertaken vow, and not penalty charged by the financier, the
agreement should reflect this concept. Therefore, the proper
wording of the penalty clause would be on the following pattern,
The client hereby undertakes that if he defaults in payment of any
of his dues under this agreement, he shall pay to the charitable
account/fund maintained by the Bank/Financier a sum calculated
on the basis of ...% per annum for each day of default unless he
establishes through the evidence satisfactory to the Bank/financier
that his non-payment at the due date was caused due to poverty
or some other factors beyond his control.
! A1-Hattab, Tahrir al-Kalam (Beirut, 1404 AH), 176.
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AN INTRODUCTION TO ISLAMIC FINANCE
4. Being a vow of charitable act, it was originally permissible for
the client to give the stipulated amount to any charity of his own
choice, but in order to ensure that he will pay, the charitable
account or fund maintained by the financier/bank is specified in the
proposed undertaking. This specific undertaking does not violate
any principle of Shari'ah. However, it is necessary that the bank or
the financial institution maintains a separate fund, or at least, a
separate account for this purpose and the amounts credited to that
account must be spent in well-defined charities known to the
client/debtor.
This proposal has now been implemented successfully in a large
number of Islamic financial institutions.
No Roll Over in Murabahah
Another rule which must be remembered and fully complied with is
that murabahah transaction cannot be rolled over for a further
period. In an interest-based financing, if a customer of the bank
cannot pay at the due date for any reason, he may request the bank
to extend the facility for another term. If the bank agrees, the
facility is rolled over on the terms and conditions mutually agreed at
that point of time, whereby the newly agreed rate of interest is
applied to the new term. It actually means that another loan of the
same amount is re-advanced to the borrower.
Some Islamic banks or financial institutions, who
misunderstood the concept of murabahah and took it as merely a
mode of financing analogous to an interest-based loan, started using
the concept of roll-over to murabahah also. If the client requests
them to extend the maturity date of murabahah, they roll it over
and extend the period of payment on an additional mark-up
charged from the client which practically means that another
separate murabahah is booked on the same commodity. This
practice is totally against the well-settled principles of Shari'ah.
It should be clearly understood that murabahah is not a loan. It
is the sale of a commodity the price of which is deferred to a specific
date. Once the commodity is sold, its ownership is passed on to the
client. It is no more a property of the seller. What the seller can
legitimately claim is the agreed price which has become a debt
98
MURABAHAH
payable by the buyer. Therefore, there is no question of effecting
another sale on the same commodity between the same parties. The
roll-over in murabahah is nothing but interest pure and simple
because it is an agreement to charge an additional amount on the
debt created by the murabahah sale.
Rebate on Earlier Payment
Sometimes the debtor wants to pay earlier than the specified date.
In this case he wants to earn a discount on the agreed deferred price.
Is it permissible to allow him a rebate for his earlier payment? This
question has been discussed by the classical jurists in detail. The
issue is known in the Islamic legal literature as "GftDH^^r" (Give
discount and receive soon). Some earlier jurists have held this
arrangement as permissible, but the majority of the Muslim jurists,
including the four recognized schools of Islamic jurisprudence do
not allow it, if the discount is held to be a condition for earlier
payment. 19
The view of those who allow this arrangement is based on a
hadith in which Abdullah ibn Abbas 4t- is reported to have said
that when the Jews belonging to the tribe of Banu Nadir were
banished from Madinah (because of their conspiracies) some people
came to the Holy Prophet j|§ and said, "You have ordered them to
be expelled, but some people owe them some debts which have not
yet matured." Thereupon the Holy Prophet #|| said to them (i.e.,
the Jews who were the creditors)
Give discount and receive (your debts) soon.
The majority of the Muslim jurists, however, does not accept
this hadith as authentic. Even Imam al-Baihaqi, who has reported
this hadith in his book, has expressly admitted that this is a weak
narration.
19 Ibn Qudamah, Al-Mughni, 4:174—75. For a full discussion, see my Arabic
book Bahuth fi Qadaya Fiqhiyyah Mu 'asirah (Q^MO^M^Z Q tyl, 25.
20 Al-Bayhaqi, al-Sunan al-Kubra, 6:28.
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AN INTRODUCTION TO ISLAMIC FINANCE
Even if the hadith is held to be authentic, the exile of Banu
Nadir was in the second year after hijrah, when riba was not yet
prohibited.
Moreover, al-Waqidi has mentioned that Banu Nadir used to
advance usurious loans. Therefore, the arrangement allowed by the
Holy Prophet j|§ was that the creditors forego the interest and the
debtors pay the principal sooner. Al-Waqidi has narrated that
Sallam ibn Abi Huqaiq, a Jew of Banu Nadir, had advanced eighty
dinars to Usaid ibn Hudayr 4^ payable after one year with an
addition of 40 dinars. Thus, Usaid 4^ owed him 120 dinars after
one year. After this arrangement, he paid the principal amount of
80 dinars and Sallam withdrew from the rest. 21
For these reasons, the majority of the jurists hold that if the
earlier payment is conditioned with discount, it is not permissible.
However, if this is not taken to be a condition for earlier payment,
and the creditor gives a rebate voluntarily on his own, it is
permissible.
The same view is taken by the Islamic Fiqh Academy in its
annual session.
It means that in a murabahah transaction effected by an Islamic
bank or financial institution, no such rebate can be stipulated in the
agreement, nor can the client claim it as his right. However, if the
bank or a financial institution gives him a rebate on its own, it is
not objectionable, especially where the client is a needy person. For
example, if a poor farmer has purchased a tractor or agricultural
inputs on the basis of murabahah, the bank should give him a
voluntary discount.
Calculation of Cost in Murabahah
It is already mentioned that the transaction of murabahah
contemplates the concept of cost-plus sale, therefore, it can be
effected only where the seller can ascertain the exact cost he has
incurred in acquiring the commodity he wants to sell. If the exact
cost cannot be ascertained, no murabahah can be possible. In this
21 Al-Waqidi, al-Maghazi, 1:374.
22 Resolution no. 66, Vlth Session of Islamic Fiqh Academy, Jeddah, Journal no.
7,2:217.
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MURABAHAH
case, the sale must be effected on the basis of musawamah (i.e. sale
without reference to cost).
This principle leads to another rule: the murabahah transaction
should be based on the same currency in which the seller has
purchased the commodity from the original supplier. If the seller
has purchased it for Pakistani rupees, the onward sale to the
ultimate purchaser should also be based on Pakistani rupees, and if
the first purchase has occurred in U.S. dollars, the price of
murabahah should be based on dollars as well, so that the exact cost
may be ascertained.
However, in the case of international trade, it may be difficult
to base both purchases on the same currency. If the commodity
intended to be sold to the customer is imported from a foreign
country, while the ultimate purchaser is in Pakistan, the price of the
original sale has to be paid in a foreign currency and the price of the
second sale will be determined in Pak. Rupees.
This situation may be met with in two ways. Firstly, if the
ultimate purchaser agrees and the laws of the country allow, the
price of the second sale may also be determined in dollars.
Secondly, if the seller has purchased the commodity by
converting Pakistani Rupees into dollars, the exact amount of Pak
rupees paid by the seller to convert them into dollars can be taken as
the cost price and the profit of murabahah can be added thereon.
In some cases, the bank purchases the commodity from abroad
at a price payable after three months or in different installments,
and sells the commodity to his client before he pays the full price to
the supplier. Since he pays the price in dollars, its equivalent in
Pakistani Rupees are not known at the time when the commodity is
sold to the client. Due to fluctuation in the price of dollars in Pak
Rupees, the bank may have to pay more than it anticipated at the
time of murabahah sale. For example, the rate of U.S. dollars at the
time of murabahah was Rs. 40/- for one dollar. The price of
murabahah was settled according to this rate, but when the bank
paid the price to the supplier, the dollar rate increased to Rs. 41/-
for one dollar, meaning thereby that the cost of the bank increased
by 2.5%. In order to meet this situation, some financial institutions
put a condition in the murabahah agreement that in case of such
fluctuation in currency rates, the client shall bear the additional
cost. According to the classical Muslim jurists, murabahah based on
101
AN INTRODUCTION TO ISLAMIC FINANCE
this condition is not valid because it leads to uncertainty of the price
at the time of sale. Such uncertainty continues upto a date after
three months when the buyer actually pays the price to the supplier.
Such uncertainty renders the transaction invalid. Therefore, there
are following options open to the bank in this issue:
(a) The bank should purchase that commodity on the basis of
L/C at sight and should pay the price to the supplier before
effecting sale with the customer. In this case no question of
fluctuation in currency rates will be involved. The murabahah price
can be determined on the basis of the market rate of dollars on the
date when the bank has paid the price to the supplier.
(b) The bank determines the murabahah price in US dollars
rather than in Pak rupees, so that the deferred murabahah price is
paid by the customer in dollars. In this case the bank will be entitled
to receive dollars from the customer and the risk of the fluctuation
in dollar's price will be borne by the purchaser.
(c) Instead of murabahah, the deal may be on the basis of
musawamah (a sale without reference to the cost of the seller) and
the price may be fixed as to cover the anticipated fluctuation in the
currency rates.
Subject Matter of Murabahah
All commodities which may be subject matter of sale with profit can
be subject matter of murabahah, because it is a particular kind of
sale. Therefore, the shares of a lawful company may be sold or
purchased on murabahah basis, because according to the Islamic
principles, the shares of a company represent the holder's
proportionate ownership in the assets of the company. If the assets
of a company can be sold with profit, its shares can also be sold by
way of murabahah. But it goes without saying that the transaction
must fulfil all the basic conditions, already discussed, for the validity
of a murabahah transaction. Therefore, the seller must first acquire
the possession of the shares with all their rights and obligations,
then sell them to his client. A buy back arrangement or selling the
shares without taking their possession is not allowed at all.
Conversely, no murabahah can be effected on things which
cannot be subject - matter of sale, For example murabahah is not
possible in exchange of currencies, because it must be spontaneous
102
MURABAHAH
or, if deferred, on the market rate prevalent on the date of the
transaction. 23 Similarly, the commercial papers representing a debt
receivable by the holder cannot be sold or purchased except at par
value, and therefore no murabahah can be effected in respect of
such papers. Similarly, any paper entitling the holder to receive a
specified amount of money from the issuer cannot be negotiated.
The only way of its sale is to transfer if for its face value. Therefore,
they cannot be sold on murabahah basis.
Rescheduling of Payments in Murabahah
If the purchaser/client in murabahah financing is not able to pay
according to the dates agreed upon in the murabahah agreement, he
sometimes requests the seller / the bank for rescheduling the
installments. In conventional banks, the loans are normally
rescheduled on the basis of additional interest. This is not possible
in murabahah payments. If the installments are rescheduled, no
additional amount can be charged for rescheduling. The amount of
the murabahah price will remain the same in the same currency.
Some Islamic banks proposed to reschedule the murabahah
price in a hard currency different from the one in which the original
sale took place. This was proposed to compensate the bank through
appreciation of the value of the hard currency. Since this benefit was
proposed to be drawn from rescheduling, it is not permissible.
Rescheduling must always be on the basis of the same amount in
the same currency. At the time of payment however, the purchaser
may pay with the consent of the seller, in a different currency on the
basis of the exchange rate of that day (i.e. the day of payment) and
not the rate of the date of transaction.
Securitization of Murabahah
Murabahah is a transaction which cannot be securitized for creating
a negotiable instrument to be sold and purchased in secondary
market. The reason is obvious. If the purchaser/client in a
murabahah transaction signs a paper to evidence his indebtedness
towards the seller/financier, the paper will represent a monetary
23 For detailed discussion on the subject, see my Arabic treatise Ahkam al-Awraq
al-Naqdiyyah ((3BiaS% S^Sb^l
103
AN INTRODUCTION TO ISLAMIC FINANCE
debt receivable from him. In other words, it represents money
payable by him. Therefore transfer of this paper to a third party will
mean transfer of money. It has already been explained that where
money is exchanged for money (in the same currency) the transfer
must be at par value. It cannot be sold or purchased at a lower or a
higher price. Therefore, the paper representing a monetary
obligation arising out of a murabahah transaction cannot create a
negotiable instrument. If the paper is transferred, it must be at par
value. However, if there is a mixed portfolio consisting of a number
of transactions like musharakah, leasing and murabahah, then this
portfolio may issue negotiable certificates subject to certain
conditions more fully discussed in the chapter of "Islamic Funds".
Some Basic Mistakes in Murabahah Financing
After explaining the concept of murabahah and its relevant issues, it
will be pertinent to highlight some basic mistakes often committed
by the financial institutions in the practical implementation of the
concept.
1. The first and the most glaring mistake is to assume that
murabahah is a universal instrument which can be used for every
type of financing offered by conventional interest-based banks and
NBFIs. 2 Under this false assumption, some financial institutions
are found using murabahah for financing overhead expenses of a
firm or company like paying salaries of their staff, paying the bills of
electricity etc. and setting off their debts payable to other parties.
This practice is totally unacceptable, because murabahah can be
used only where a commodity is intended to be purchased by the
customer. If funds are required for some other purpose, murabahah
cannot work. In such cases, some other suitable modes of financing,
like musharakah, leasing etc. can be used according to the nature of
the requirement.
2. In some cases, the clients sign the murabahah documents
merely to obtain funds. They never intend to employ these funds to
purchase a specific commodity. They just want funds for
unspecified purpose, but to satisfy the requirement of the formal
NBFI: Non-Bank Financial Institution.
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MURABAHAH
documents, they name a fictitiously commodity. After receiving
money, they use it for whatever purpose they wish.
Obviously this is a fictitious deal, and the Islamic financiers
must be very careful about it. It is their duty to make sure that the
client really intends to purchase a commodity which may be subject
to murabahah. This assurance must be obtained by the authorities
sanctioning the facility to the customer. Then, all necessary steps
must be taken to confirm that the transaction is genuine. For
example:
(a) Instead of giving funds to the customer, the purchase price
should be paid directly to the supplier.
(b) If it becomes necessary that the client is entrusted with funds
to purchase the commodity on behalf of the financier, his purchase
should be evidenced by invoices or similar other documents which
he should present to the financier.
(c) Where either one of the above two requirements is not
possible to be fulfilled, the financing institution should arrange for
physical inspection of the purchased commodities.
Anyhow, the Islamic financial institutions are under an
obligation to make sure that murabahah is a real and genuine
transaction of actual sale and is not being misused to camouflage an
interest-based loan.
3. In some cases, sale of commodity to the client is effected
before the commodity is acquired from the supplier. This mistake is
invariably committed in transactions where all the documents of
murabahah are signed at one time without taking into account
various stages of the murabahah. Some institutions have only one
murabahah agreement which is signed at the time of disbursement
of money, or in some cases, at the time of approving the facility.
This is totally against the basic principles of murabahah. It has
already been explained in this article that the murabahah
arrangement practiced by the banks is a package of different
contracts which come into play one after another at their respective
stages. These stages have been fully highlighted earlier while
discussing the concept of murabahah financing. Without observing
this basic feature of murabahah financing, the whole transaction
turns into an interest-bearing loan. Merely changing the
nomenclature does not make it lawful in the eyes of Shari'ah.
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AN INTRODUCTION TO ISLAMIC FINANCE
The representatives of the Shari'ah Boards of the Islamic banks,
when they check the transactions of the bank with regard to their
compliance with Shari'ah, must make sure that all these stages have
been really observed, and every transaction is effected at its due
time.
4. International commodity transactions are often resorted to
for liquidity management. Some Islamic banks feel that these
transactions, being asset-based, can easily be entered into on
murabahah basis, and they enter the field ignoring the fact that the
commodity operations as in vogue in the international markets, do
not conform to the principles of Shari'ah. In many cases, they are
fictitious transactions where no delivery takes place. The parties end
up paying differences. In some cases, there are real commodities but
they are subjected to forward sales or short sales which are not
allowed in Shari'ah. Even if the transactions are restricted to spot
sales, they should be formulated on the basis of Islamic principles of
murabahah by fulfilling all the necessary conditions already
mentioned in this book.
5. It is observed in some financial institutions that they effect
murabahah on commodities already purchased by their clients from
a third party. This is again a practice never warranted by the
Shari'ah. Once the commodity is purchased by the client himself, it
cannot be purchased again from the same supplier. If it is purchased
by the bank from the client himself and is sold to him, it is a buy-
back technique which is not allowed in Shari'ah, especially in
murabahah. In fact, if the client has already purchased a
commodity, and he approaches the bank for funds, he either wants
to set-off his liability towards his supplier, or he wants to use the
funds for some other purpose. In both cases an Islamic bank cannot
finance him on the basis of murabahah. Murabahah can be effected
only on commodities not yet purchased by the client.
Conclusions
From the foregoing discussion on different aspects of murabahah
financing, the following conclusions may be summarized as the
basic points to remember:
1. Murabahah is not a mode of financing in its origin. It is a
simple sale on cost-plus basis. However, after adding the concept of
106
MURABAHAH
deferred payment, it has been devised to be used as a mode of
financing only in cases where the client intends to purchase a
commodity. Therefore, it should neither be taken as an ideal Islamic
mode of financing, nor a universal instrument for all sorts of
financing. It should be taken as a transitory step towards the ideal
Islamic system of financing based on musharakah or mudarabah.
Otherwise its use should be restricted to areas where musharakah or
mudarabah cannot work.
2. While approving a murabahah facility, the sanctioning
authority must make sure that the client really intends to purchase
commodities which may be subject-matter of murabahah. It should
never be taken as merely a paper-work having no genuine basis.
3. No murabahah can be effected for overhead expenses, paying
the bills or settling the debts of the client, nor can it be effected for
purchase of currencies.
4. It is the foremost condition for the validity of murabahah
that the commodity comes in the ownership and physical or
constructive possession of the financier before he sells it to the
customer on murabahah basis. There should be a time in which the
risk of the commodity is borne by the financier. Without having its
ownership or assuming the risk of the commodity, though for a
short while, the transaction is not acceptable to Shari'ah and the
profit accruing therefrom is not halal.
5. The best way to effect murabahah is that the financier himself
purchases the commodity directly from the supplier and after taking
its delivery sells it to the client on murabahah basis. Making the
client agent to purchase on behalf of the financier renders the
arrangement dubious. For this very reason some Shari'ah Boards
have forbidden this technique, except in cases where direct purchase
is not possible at all. Therefore, the agency concept should be
avoided as far as possible.
6. If in cases of genuine need, the financier appoints the client
his agent to purchase the commodity on his behalf, his different
capacities (i.e. as agent and as ultimate purchaser) should be clearly
distinguished. As an agent, he is a trustee, and unless he commits
negligence or fraud, he is not liable to any loss so far as the
commodity is in his possession as agent of the financier. After he
purchases the commodity in his capacity as agent, he must inform
the financier that, in fulfilling his obligation as his agent, he has
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AN INTRODUCTION TO ISLAMIC FINANCE
taken delivery of the purchased commodity and now he extends his
offer to purchase it from him. When, in response to this offer, the
financier conveys his acceptance to this offer, the sale will be
deemed to be complete, and the risk of the property will be passed
on to the client as purchaser. At this point, he will become a debtor
and the consequences of indebtedness will follow. These are the
necessary requirements of murabahah financing which can never be
dispensed with. While describing the concept of "murabahah as a
mode of financing" we have already identified five stages of
murabahah under agency agreement. Each and every step out of
these five is necessary in its own right and neglecting any one of
them renders the whole arrangement unacceptable.
It should be noted with care that murabahah is a border-line
transaction and a slight departure from the prescribed procedure
makes it step in the prohibited area of interest-based financing.
Therefore this transaction must be carried out with due diligence
and no requirement of Shari'ah should be taken lightly.
7. Two different prices for cash and credit sales are allowed on
condition that either of the two options is specifically elected by the
customer. Once the price is fixed, it can neither be increased
because of late payment, nor decreased on earlier payment.
8. In order to assure that the purchaser will pay the price
promptly, he may undertake that in case of default, he will pay a
certain amount to the charitable fund maintained by the financing
institution. This amount may be based on per cent per annum
concept, but it must invariably be spent for purely charitable
purposes and should in no case form part of the income of the
institution.
9. In case of earlier payment, no rebate can be claimed by the
client. However, the institution may at it own option, forego some
part of the price without making it a pre-condition in the
agreement.
108
6
IjARAH
"Ijarah" is a term of Islamic fiqh. Lexically, it means 'to give
something on rent'. In the Islamic jurisprudence, the term 'ijarah is
used for two different situations. In the first place, it means 'to
employ the services of a person on wages given to him as a
consideration for his hired services.' The employer is called musta'jir
while the employee is called ajir.
Therefore, if A has employed B in his office as a manager or as a
clerk on a monthly salary, A is musta'jir, and B is an ajir. Similarly,
if A has hired the services of a porter to carry his baggage to the
airport, A is a musta'jir while the porter is an ajir, and in both cases
the transaction between the parties is termed as ijarah. This type of
ijarah includes every transaction where the services of a person are
hired by someone else. He may be a doctor, a lawyer, a teacher, a
laborer or any other person who can render some valuable services.
Each one of them may be called an 'ajir' according to the
terminology of Islamic law, and the person who hires their services
is called a 'musta'jir', while the wages paid to the ajir are called their
'ujrah'.
The second type of ijarah relates to the usufructs of assets and
properties, and not to the services of human beings. 'Ijarah' in this
sense means 'to transfer the usufruct of a particular property to
another person in exchange for a rent claimed from him.' In this
case, the term 'ijarah' is analogous to the English term 'leasing'.
Here the lessor is called 'mu'jif ', the lessee is called 'musta'jir and
the rent payable to the lessor is called 'ujrah '.
Both these kinds of 'ijarah' are thoroughly discussed in the
literature of Islamic jurisprudence and each one of them has its own
AN INTRODUCTION TO ISLAMIC FINANCE
set of rules. But for the purpose of the present book, the second
type of ijarah is more relevant, because it is generally used as a form
of investment, and as a mode of financing also.
The rules of ijarah, in the sense of leasing, is very much
analogous to the rules of sale, because in both cases something is
transferred to another person for a valuable consideration. The only
difference between ijarah and sale is that in the latter case the corpus
of the property is transferred to the purchaser, while in the case of
ijarah, the corpus of the property remains in the ownership of the
transferor, but only its usufruct i.e. the right to use it, is transferred
to the lessee.
Therefore, it can easily be seen that 'ijarah' is not a mode of
financing in its origin. It is a normal business activity like sale.
However, due to certain reasons, and in particular, due to some tax
concessions it may carry, this transaction is being used in the
Western countries for the purpose of financing also. Instead of
giving a simple interest - bearing loan, some financial institutions
started leasing some equipment's to their customers. While fixing
the rent of these equipment, they calculate the total cost they have
incurred in the purchase of these assets and add the stipulated
interest they could have claimed on such an amount during the
lease period. The aggregate amount so calculated is divided on the
total months of the lease period, and the monthly rent is fixed on
that basis.
The question whether or not the transaction of leasing can be
used as a mode of financing in Shari'ah depends on the terms and
conditions of the contract. As mentioned earlier, leasing is a normal
business transaction and not a mode of financing. Therefore, the
lease transaction is always governed by the rules of Shari'ah
prescribed for ijarah. Let us, therefore, discuss the basic rules
governing the lease transactions, as enumerated in the Islamic Fiqh.
After the study of these rules, we will be able to understand under
what conditions the ijarah may be used for the purpose of
financing.
Although the principles of ijarah are so numerous that a separate
volume is required for their full discussion, we will attempt in this
chapter to summarize those basic principles only which are
necessary for the proper understanding of the nature of the
transaction and are generally needed in the context of modern
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MURABAHAH
economic practice. These principles are recorded here in the form of
brief notes, so that the readers may use them for quick reference.
Basic Rules of Leasing
1. Leasing is a contract whereby the owner of something
transfers its usufruct to another person for an agreed period, at an
agreed consideration.
2. The subject of lease must have a valuable use. Therefore,
things having no usufruct at all cannot be leased.
3. It is necessary for a valid contract of lease that the corpus of
the leased property remains in the ownership of the seller, and only
its usufruct is transferred to the lessee. Thus, anything which cannot
be used without consuming cannot be leased out. Therefore, the
lease cannot be effected in respect of money, eatables, fuel and
ammunition etc. because their use is not possible unless they are
consumed. If anything of this nature is leased out, it will be deemed
to be a loan and all the rules concerning the transaction of loan shall
accordingly apply. Any rent charged on this invalid lease shall be an
interest charged on a loan.
4. As the corpus of the leased property remains in the ownership
of the lessor, all the liabilities emerging from the ownership shall be
borne by the lessor, but the liabilities referable to the use of the
property shall be borne by the lessee.
Example:
A has leased his house to B. The taxes referable to the property
shall be borne by A, while the water tax, electricity bills and all
expenses referable to the use of the house shall be borne by B,
the lessee.
5. The period of lease must be determined in clear terms.
6. The lessee cannot use the leased asset for any purpose other
than the purpose specified in the lease agreement. If no such
purpose is specified in the agreement, the lessee can use it for
whatever purpose it is used in the normal course. However if he
wishes to use it for an abnormal purpose, he cannot do so unless the
lessor allows him in express terms.
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7. The lessee is liable to compensate the lessor for every harm to
the leased asset caused by any misuse or negligence on the part of
the lessee.
8. The leased asset shall remain in the risk of the lessor
throughout the lease period in the sense that any harm or loss
caused by the factors beyond the control of the lessee shall be borne
by the lessor.
9. A property jointly owned by two or more persons can be
leased out, and the rental shall be distributed between all the joint
owners according to the proportion of their respective shares in the
property.
10. A joint owner of a property can lease his proportionate share
to his co-sharer only, and not to any other person. :
11. It is necessary for a valid lease that the leased asset is fully
identified by the parties.
Example:
A said to B. "I lease you one of my two shops." B agreed. The
lease is void, unless the leased shop is clearly determined and
identified.
12. The rental must be determined at the time of contract for
the whole period of lease.
It is permissible that different amounts of rent are fixed for
different phases during the lease period, provided that the amount
of rent for each phase is specifically agreed upon at the time of
effecting a lease. If the rent for a subsequent phase of the lease
period has not been determined or has been left at the option of the
lessor, the lease is not valid.
Example (1): A leases his house to B for a total period of 5 years.
The rent for the first year is fixed as Rs. 2000/- per month and
it is agreed that the rent of every subsequent year shall be 1 0%
more than the previous one. The lease is valid.
Example (2): In the above example, A puts a condition in the
agreement that the rent of Rs. 2000/- per month is fixed for the
1 See Ibn Abidin, Radd al-Muhtar, 6:47-48.
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first year only. The rent for the subsequent years shall be fixed
each year at the option of the lessor. The lease is void, because
the rent is uncertain.
The determination of rental on the basis of the aggregate cost
incurred in the purchase of the asset by the lessor, as normally done
in financial leases, is not against the rules of Shari'ah, if both parties
agree to it, provided that all other conditions of a valid lease
prescribed by the Shari'ah are fully adhered to.
14. The lessor cannot increase the rent unilaterally, and any
agreement to to this effect is void.
15. The rent or any part thereof may be payable in advance
before the delivery of the asset to the lessee, but the amount so
collected by the lessor shall remain with him as 'on account'
payment and shall be adjusted towards the rent after its being due.
16. The lease period shall commence from the date on which
the leased asset has been delivered to the lessee, no matter whether
the lessee has started using it or not.
17. If the leased asset has totally lost the function for which it
was leased, and no repair is possible, the lease shall terminate on the
day on which such loss has been caused. However, if the loss is
caused by the misuse or by the negligence of the lessee, he will be
liable to compensate the lessor for the depreciated value of the asset
as, it was immediately before the loss.
Lease as a Mode of Financing
Like murabahah, lease is not originally a mode of financing. It is
simply a transaction meant to transfer the usufruct of a property
from one person to another for an agreed period against an agreed
consideration. However, certain financial institutions have adopted
leasing as a mode of financing instead of long term lending on the
basis of interest. This kind of lease is generally known as the
'financial lease' as distinguished from the 'operating lease' and many
basic features of actual leasing transaction have been dispensed with
therein.
When interest-free financial institutions were established in the
near past, they found that leasing is a recognized mode of finance
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throughout the world. On the other hand, they realized that leasing
is a lawful transaction according to Shari'ah and it can be used as an
interest-free mode of financing. Therefore, leasing has been adopted
by the Islamic financial institutions, but very few of them paid
attention to the fact that the 'financial lease' has a number of
characteristics more similar to interest than to the actual lease
transaction. That is why they started using the same model
agreements of leasing as were in vogue among the conventional
financial institutions without any modification, while a number of
their provisions were not in conformity with Shari'ah.
As mentioned earlier, leasing is not a mode of financing in its
origin. However, the transaction may be used for financing, subject
to certain conditions. It is not sufficient for this purpose to
substitute the name of 'interest' by the name of 'rent' and replace
the name of 'mortgage' by the name of 'leased asset'. There must be
a substantial difference between leasing and an interest-bearing loan.
That will be possible only by following all the Islamic rules of
leasing, some of which have been mentioned in the first part of this
chapter.
To be more specific, some basic differences between the
contemporary financial leasing and the actual leasing allowed by the
Shari'ah are indicated below.
i. The Commencement of Lease
Unlike the contract of sale, the agreement of ijarah can be effected
for a future date. Thus, while a forward sale is not allowed in
Shari'ah, an 'ijarah' for a future date is allowed, on the condition
that the rent will be payable only after the leased asset is delivered to
the lessee.
In most cases of the 'financial lease' the lessor i.e. the financial
institution purchases the asset through the lessee himself. The lessee
purchases the asset on behalf of the lessor who pays its price to the
supplier, either directly or through the lessee. In some lease
agreements, the lease commences on the very day on which the
price is paid by the lessor, irrespective of whether the lessee has
effected payment to the supplier and taken delivery of the asset or
See Ibn 'Abidin, Radd al-Muhtar, 4:64.
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not. It may mean that lessee's liability for the rent starts before the
lessee takes delivery of the asset. This is not allowed in Shari'ah,
because it amounts to charging rent on the money given to the
customer which is nothing but interest, pure and simple.
The correct way, according to Shari'ah, is that the rent be
charged after the lessee has taken delivery of the asset, and not from
the day the price has been paid. If the supplier has delayed the
delivery after receiving the full price, the lessee should not be liable
for the rent of the period of delay.
2. Different Relations of the Parties
It should be clearly understood that when the lessee himself has
been entrusted with the purchase of the asset intended to be leased,
there are two separate relations between the institution and the
client which come into operation one after the other. In the first
instance, the client is an agent of the institution to purchase the
asset on latter's behalf. At this stage, the relation between the parties
is nothing more than the relation of a principal and his agent. The
relation of lessor and lessee has not yet come into operation.
The second stage begins from the date when the client takes
delivery from the supplier. At this stage, the relation of lessor and
lessee comes to play its role. These two capacities of the parties
should not be mixed up or confused with each other. During the
first stage, the client cannot be held liable for the obligations of a
lessee. In this period, he is responsible to carry out the functions of
an agent only. But when the asset is delivered to him, he is liable to
discharge his obligations as a lessee.
However, there is a point of difference between murabahah and
leasing. In murabahah, as mentioned earlier, actual sale should take
place after the client takes delivery from the supplier, and the
previous agreement of murabahah is not enough for effecting the
actual sale. Therefore, after taking possession of the asset as an
agent, he is bound to give intimation to the institution, and make
an offer for the purchase from him. The sale takes place after the
institution accepts the offer.
The procedure in leasing is different, and a little shorter. Here
the parties need not effect the lease contract after taking delivery. If
the institution, while appointing the client its agent, has agreed to
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lease the asset with effect from the date of delivery, the lease will
automatically start on that date without any additional procedure.
There are two reasons for this difference between murabahah and
leasing:
Firstly, it is a necessary condition for a valid sale that it should
be effected instantly. Thus, a sale attributed to a future date is
invalid in Shari'ah. But leasing can be attributed to a future date.
Therefore, the previous agreement is not sufficient in the case of
murabahah, while it is quite enough in the case of leasing.
Secondly, the basic principle of Shari'ah is that one cannot
claim a profit or a fee for a property the risk of which was never
borne by him. Applying this principle to murabahah, the seller
cannot claim a profit over a property which never remained under
his risk for a moment. Therefore, if the previous agreement is held
to be sufficient for effecting a sale between the client and the
institution, the asset shall be transferred to the client simultaneously
when he takes its possession, and the asset shall not come into the
risk of the seller even for a moment. That is why the simultaneous
transfer is not possible in murabahah, and there should be a fresh
offer and acceptance after the delivery.
In leasing, however, the asset remains under the risk and
ownership of the lessor throughout the leasing period, because the
ownership has not been transferred. Therefore, if the lease period
begins right from the time when the client has taken delivery, it
does not violate the principle mentioned above.
3. Expenses Consequent to Ownership
As the lessor is the owner of the asset, and he has purchased it from
the supplier through his agent, he is liable to pay all the expenses
incurred in the process of its purchase and its import to the country
of the lessor. Consequently, he is liable to pay the freight and the
customs duty etc. He can, of course, include all these expenses in his
cost and can take them into consideration while fixing the rentals,
but as a matter of principle, he is liable to bear all these expenses as
the owner of the asset. Any agreement to the contrary, as is found in
the traditional financial leases, is not in conformity with Shari'ah.
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4. Liability of the Parties in Case of Loss to the
Asset
As mentioned in the basic principles of leasing, the lessee is
responsible for any loss caused to the asset by his misuse or
negligence. He can also be made liable to the wear and tear which
normally occurs during its use. But he cannot be made liable to a
loss caused by the factors beyond his control. The agreements of the
traditional 'financial lease' generally do not differentiate between the
two situations. In a lease based on the Islamic principles, both the
situations should be dealt with separately.
5. Variable Rentals in Long Term Leases
In the long term lease agreements it is mostly not in the benefit of
the lessor to fix one amount of rent for the whole period of lease,
because the market conditions change from time to time.
In this case the lessor has two options:
(a) He can contract lease with a condition that the rent shall be
increased according to a specified proportion (e.g. 5%) after a
specified period (like one year) .
(b) He can contract lease for a shorter period after which the
parties can renew the lease at new terms and by mutual consent,
with full liberty to each one of them to refuse the renewal, in which
case the lessee is bound to vacate the leased property and return it
back to the lessor.
These two options are available to the lessor according to the
classical rules of Islamic Fiqh. However, some contemporary
scholars have allowed, in long-term leases, to tie up the rental
amount with a variable benchmark which is so well-known and
well-defined that it does not leave room for any dispute. For
example, it is permissible according to them to provide in the lease
contract that in case of any increase in the taxes imposed by the
government on the lessor, the rent will be increased to the extent of
same amount. Similarly it is allowed by them that the annual
increase in the rent is tied up with the rate of inflation. Therefore if
there is an increase of 5% in the rate of inflation, it will result in an
increase of 5% in the rent as well. Based on the same principle,
some Islamic banks use the rate of interest as a benchmark to
determine the rental amounts. They want to earn the same profit
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through leasing as is earned by the conventional banks through
advancing loans on the basis of interest. Therefore, they want to tie
up the rentals with the rate of interest and instead of fixing a
definite amount of rental, they calculate the cost of purchasing the
lease assets and want to earn through rentals an amount equal to the
rate of interest. Therefore, the agreement provides that the rental
will be equal to the rate of interest or to the rate of interest plus
something. Since the rate of interest is variable, it cannot be
determined for the whole lease period. Therefore, these contracts
use the interest rate of a particular country (like LIBOR) as a
benchmark for determining the periodical increase in the rent.
This arrangement has been criticized on two grounds:
The first objection raised against it is that, by subjecting the
rental payments to the rate of interest, the transaction is rendered
akin to an interest based financing. This objection can be overcome
by saying that, as fully discussed in the case of murabahah, the rate
of interest is used as a benchmark only. So far as other requirements
of Shari'ah for a valid lease are properly fulfilled, the contract may
use any benchmark for determining the amount of rental. The basic
difference between an interest - based financing and a valid lease
does not lie in the amount to be paid to the financier or the lessor.
The basic difference is that in the case of lease, the lessor assumes
the full risk of the corpus of the leased asset. If the asset is destroyed
during the lease period, the lessor will suffer the loss. Similarly, if
the leased asset looses its usufruct without any misuse or negligence
on the part of the lessee, the lessor cannot claim the rent, while in
the case of an interest-based financing, the financier is entitled to
receive interest, even if the debtor did not at all benefit from the
money borrowed. So far as this basic difference is maintained, (i.e.
the lessor assumes the risk of the leased asset) the transaction cannot
be categorised as an interest-bearing transaction, even though the
amount of rent claimed from the lessee is equal to the rate of
interest.
It is thus clear that the use of the rate of interest merely as a
benchmark does not render the contract invalid as an interest -
based transaction. It is, however, advisable at all times to avoid
using interest even as a benchmark, so that an Islamic transaction is
totally distinguished from an un-Islamic one, having no
resemblance of interest whatsoever.
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The second objection to this arrangement is that the variations
of the rate of interest being unknown, the rental tied up with the
rate of interest will imply jahalah and gharar which is not
permissible in Shari'ah. It is one of the basic requirements of
Shari'ah that the consideration in every contract must be known to
the parties when they enter into it. The consideration in a
transaction of lease is the rent charged from the lessee, and therefore
it must be known to each party right at the beginning of the
contract of lease. If we tie up the rental with the future rate of
interest, which is unknown, the amount of rent will remain
unknown as well. This is the jahalah or gharar which renders the
transaction invalid.
Responding to this objection, one may say that the jahalah has
been prohibited for two reasons: One reason is that it may lead to
dispute between the parties. This reason is not applicable here,
because both parties have agreed with mutual consent upon a well
defined benchmark that will serve as a criterion for determining the
rent, and whatever amount is determined, based on this benchmark,
will be acceptable to both parties. Therefore, there is no question of
any dispute between them.
The second reason for the prohibition of jahalah is that it
renders the parties susceptible to an unforeseen loss. It is possible
that the rate of interest, in a particular period, zooms up to an
unexpected level in which case the lessee will suffer. It is equally
possible that the rate of interest zooms down to an unexpected level,
in which case the lessor may suffer. In order to meet the risks
involved in such possibilities, it is suggested by some contemporary
scholars that the relation between rent and the rate of interest is
subjected to a limit or ceiling. For example, it may be provided in
the base contract that the rental amount after a given period, will be
changed according to the change in the rate of interest, but it will in
no case be higher than 15% or lower than 5% of the previous
monthly rent. It will mean that if the increase in the rate of interest
is more than 15% the rent will be increased only up to 15%.
Conversely, if the decrease in the rate of interest is more than 5%
the rent will not be decreased to more than 5%. In our opinion, this
is the moderate view which takes care of all the aspects involved in
the issue.
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6. Penalty for Late Payment of Rent
In some agreements of financial leases, a penalty is imposed on the
lessee in case he delays the payment of rent after the due date. This
penalty, if meant to add to the income of the lessor, is not
warranted by the Shari'ah. The reason is that the rent after it
becomes due, is a debt payable by the lessee, and is subject to all the
rules prescribed for a debt. A monetary charge from a debtor for his
late payment is exactly the riba prohibited by the Holy Qur'an.
Therefore, the lessor cannot charge an additional amount in case the
lessee delays payment of the rent.
However, in order to avoid the adverse consequences resulting
from the misuse of this prohibition, another alternative may be
resorted to. The lessee may be asked to undertake that, if he fails to
pay rent on its due date, he will pay certain amount to a charity. For
this purpose the financier / lessor may maintain a charity fund
where such amounts may be credited and disbursed for charitable
purposes, including advancing interest-free loans to the needy
persons. The amount payable for charitable purposes by the lessee
may vary according to the period of default and may be calculated
at per cent, per annum basis. The agreement of the lease may
contain the following clause for this purpose:
The Lessee hereby undertakes that, if he fails to pay rent at its due
date, he shall pay an amount calculated at ....% p. a. to the charity
Fund maintained by the Lessor which will be used by the Lessor
exclusively for charitable purposes approved by the Shari'ah and
shall in no case form part of the income of the Lessor.
This arrangement, though does not compensate the lessor for
his opportunity cost of the period of default, yet it may serve as a
strong deterrent for the lessee to pay the rent promptly.
The justification for such undertaking of the lessee, and
inability of any penalty or compensation claimed by the lessor for
his own benefit is discussed in full in the chapter of murabahah in
the present book which may be consulted for details.
7. Termination of Lease
If the lessee contravenes any term of the agreement, the lessor has a
right to terminate the lease contract unilaterally. However, if there
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is no contravention on the part of the lessee, the lease cannot be
terminated without mutual consent. In some agreements of the
'financial lease' it has been noticed that the lessor has been given an
unrestricted power to terminate the lease unilaterally whenever he
wishes, according to his sole judgment. This is again contrary to the
principles of Shari'ah.
In some agreements of the 'financial lease' a condition has been
found to the effect that in case of the termination of lease, even at
the option of the lessor, the rent of the remaining lease period shall
be paid by the lessee. This condition is obviously against Shari'ah
and the principles of equity and justice. The basic reason for
inserting such conditions in the agreement of lease is that the main
concept behind the agreement is to give an interest-bearing loan
under the ostensible cover of lease. That is why every effort is made
to avoid the logical consequences of the lease contract.
Naturally, such a condition cannot be acceptable to Shari'ah.
The logical consequence of the termination of lease is that the asset
should be taken back by the lessor. The lessee should be asked to
pay the rent as due up to the date of termination. If the termination
has been effected due to the misuse or negligence on the part of the
lessee, he can also be asked to compensate the lessor for the loss
caused by such misuse or negligence. But he cannot be compelled to
pay the rent of the remaining period.
8. Insurance of the Assets
If the leased property is insured under the Islamic mode of takajul,
it should be at the expense of the lessor and not at the expense of
the lessee, as is generally provided in the agreements of the current
'financial leases'.
9. The Residual Value of the Leased Asset
Another important feature of the modern 'financial leases' is that
after the expiry of the lease period, the corpus of the leased asset is
normally transferred to the lessee. As the lessor already recovers his
cost along with an additional profit thereon, which is normally
equal to the amount of interest which could have been earned on a
loan of that amount advanced for that period, the lessor has no
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further interest in the leased asset. On the other hand, the lessee
wants to retain the asset after the expiry of the leased period.
For these reasons, the leased asset is generally transferred to the
lessee at the end of the lease, either free of any charge or at a
nominal token price. In order to ensure that the asset will be
transferred to the lessee, sometimes the lease contract has an express
clause to this effect. Sometimes this condition is not mentioned in
the contract expressly; however, it is understood between the parties
that the title of the asset will be passed on to the lessee at the end of
the lease term.
This condition, whether it is express or implied, is not in
accordance with the principles of Shari'ah. It is a well settled rule of
Islamic jurisprudence that one transaction cannot be tied up with
another transaction so as to make the former a pre-condition for the
other. Here the transfer of the asset at the end has been made a
necessary condition for the transaction of lease which is not allowed
in Shari'ah.
The original position in Shari'ah is that the asset shall be the
sole property of the lessor, and after the expiry of the lease period,
the lessor shall be at liberty to take the asset back, or to renew the
lease or to lease it out to another party, or sell it to the lessee or to
any other person. The lessee cannot force him to sell it to him at a
nominal price, nor can such a condition be imposed on the lessor in
the lease agreement.
But after the lease period expires, and the lessor wants to give
the asset to the lessee as a gift or to sell it to him, he can do so by his
free will. However, some contemporary scholars, keeping in view
the needs of the Islamic financial institutions have come up with an
alternative. They say that the agreement of ijarah itself should not
contain a condition of gift or sale at the end of the lease period.
However, the lessor may enter into a unilateral promise to sell the
leased asset to the lessee at the end of the lease period. This promise
will be binding on the lessor only. The principle, according to
them, is that a unilateral promise to enter into a contract at a future
date is allowed whereby the promisor is bound to fulfil the promise,
but the promisee is not bound to enter into that contract . It means
that he has an option to purchase which he may or may not
exercise. However, if he wants to exercise his option to purchase,
the promisor cannot refuse it because he is bound by his promise.
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Therefore, these scholars suggest that the lessor, after entering into
the lease agreement, can sign a separate unilateral promise whereby
he undertakes that if the lessee has paid all the amounts of rentals
and wants to purchase the asset at a specified mutually acceptable
price, he will sell the leased asset to him for that price.
Once this promise is signed by the lessor, he is bound to fulfil it
and the lessee may exercise his option to purchase at the end of the
period, if he has fully paid the amounts of rent according to the
agreement of lease. Similarly, it is also allowed by these scholars
that, instead of sale, the lessor signs a separate promise to gift the
leased asset to the lessee at the end of the lease period, subject to his
payment of all amounts of rent. This arrangement is called 'ijarah
wa iqtind . It has been allowed by a large number of contemporary
scholars and is widely acted upon by the Islamic banks and financial
institutions. The validity of this arrangement is subject to two basic
conditions:
Firstly, the agreement of ijarah itself should not be subjected to
signing this promise of sale or gift but the promise should he
recorded in a separate document.
Secondly, the promise should be unilateral and binding on the
promisor only. It should not be a bilateral promise binding on both
parties because in this case it will be a full contract effected to a
future date which is not allowed in the case of sale or gift.
10. Sub-Lease
If the leased asset is used differently by different users, the lessee
cannot sub-lease the leased asset except with the express permission
of the lessor. If the lessor permits the lessee for subleasing, he may
sub-lease it. If the rent claimed from the sub-lessee is equal to or less
than the rent payable to the owner / original lessor, all the
recognized schools of Islamic jurisprudence are unanimous on the
permissibility of the sub lease. However, the opinions are different
in case the rent charged from the sub-lessee is higher than the rent
payable to the owner. Imam al-Shafi'i and some other scholars allow
it and hold that the sub lessor may enjoy the surplus received from
the sub-lessee. This is the preferred view in the Hanbali school as
well. On the other hand. Imam Abu Hanifah is of the view that the
surplus received from the sub-lessee in this case is not permissible
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for the sub-lessor to keep and he will have to give that surplus in
charity. However, if the sub-lessor has developed the leased property
by adding something to it or has rented it in a currency different
from the currency in which he himself pays rent to the owner/the
original lessor, he can claim a higher rent from his sub-lessee and
can enjoy the surplus. 3
Although the view of Imam Abu Hanifah is more precautious
which should be acted upon to the best possible extent, in cases of
need the view of Shafi'i and Hanbali schools may be followed
because there is no express prohibition in the Holy Qur'an or in the
Sunnah against the surplus claimed from the lessee. Ibn Qudamah
has argued for the permissibility of surplus on forceful grounds.
ii. Assigning of the Lease
The lessor can sell the leased property to a third party whereby the
relation of lessor and lessee shall be established between the new
owner and the lessee. However, the assigning of the lease itself
(without assigning the ownership in the leased asset) for a monetary
consideration is not permissible.
The difference between the two situations is that in the latter
case the ownership of the asset is not transferred to the assignee, but
he becomes entitled to receive the rent of the asset only. This kind
of assignment is allowed in Shari'ah only where no monetary
consideration is charged from the assignee for this assignment, for
example, a lessor can assign his right to claim rent from the lessee to
his son, or to his friend in the form of a gift. Similarly, he can assign
this right to any one of his creditors to set off his debt out of the
rentals received by him. But if the lessor wants to sell this right for a
fixed price, it is not permissible, because in this case the money (the
amount of rentals) is sold for money which is a transaction subject
to the principle of equality. Otherwise it will be tantamount to a
riba transaction, hence prohibited.
3 See Ibn Qudamah, Al-Mughni (Riyadh, 1981), 5:475; Ibn 'Abidin, Radd al-
MuJitar, 5:20.
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Securitization of Ijarah
The arrangement of ijarah has a good potential of securitization
which may help create a secondary market for the financiers on the
basis of ijarah. Since the lessor in ijarah owns the leased assets, he
can sell the asset, in whole or in part, to a third party who may
purchase it and may replace the seller in the rights and obligations
of the lessor with regard to the purchased part of the asset.
Therefore, if the lessor, after entering into ijarah, wishes to
recover his cost of purchase of the asset with a profit thereon, he can
sell the leased asset wholly or partly either to one party or to a
number of individuals. In the latter case, the purchase of a
proportion of the asset by each individual may be evidenced by a
certificate which may be called 'ijarah certificate'. This certificate
will represent the holder's proportionate ownership in the leased
asset and he will assume the rights and obligations of the
owner/lessor to that extent. Since the asset is already leased to the
lessee, lease will continue with the new owners, each one of the
holders of this certificate will have the right to enjoy a part of the
rent according to his proportion of ownership in the asset. Similarly
he will also assume the obligations of the lessor to the extent of his
ownership. Therefore, in the case of total destruction of the asset, he
will suffer the loss to the extent of his ownership. These certificates,
being an evidence of proportionate ownership in a tangible asset,
can be negotiated and traded in freely in the market and can serve as
an instrument easily convertible into cash. Thus they may help in
solving the problems of liquidity management faced by the Islamic
banks and financial institutions.
It should be remembered, however, that the certificate must
represent ownership of an undivided part of the asset with all its
rights and obligations. Misunderstanding this basic concept, some
quarters tried to issue ijarah certificates representing the holder's
right to claim certain amount of the rental only without assigning to
him any kind of ownership in the asset. It means that the holder of
such a certificate has no relation with the leased asset at all. His only
Some jurists are of the opinion that this sale will not take effect until the lease
period is over. However, Imam Abu Yusuf and other jurists are of the view that
the sale is valid, the purchaser will replace the seller, and ijarah may continue.
(See Ibn 'Abidin, Radd al-Muhtar, 4:57)
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right is to share the rentals received from the lessee. This type of
securitization is not allowed in Shari'ah. As explained earlier in this
chapter, the rent after being due is a debt payable by the lessee. The
debt or any security representing debt only is not a negotiable
instrument in Shari'ah, because trading in such an instrument
amounts to trade in money or in monetary obligation which is not
allowed, except on the basis of equality, and if the equality of value
is observed while trading in such instruments, the very purpose of
securitization is defeated. Therefore, this type of ijarah certificates
cannot serve the purpose of creating a secondary market. It is,
therefore, necessary that the ijarah certificates are designed to
represent real ownership of the leased assets, and not only a right to
receive rent.
Head-Lease
Another concept developed in the modern leasing business is that of
'head-leasing.' In this arrangement a lessee sub-leases the property to
a number of sub-lessees. Then, he invites others to participate in his
business by making them share the rentals received by his sub-
lessees. For making them participate in receiving rentals, he charges
a specified amount from them. This arrangement is not in
accordance with the principles of Shari'ah. The reason is obvious.
The lessee does not own the property. He is entitled to benefit from
its usufruct only. That usufruct he has passed on to his sub-lessees
by contracting a sub-lease with them. Now he does not own
anything, neither the corpus of the property, nor its usufruct. What
he has is the right to receive rent only. Therefore, he assigns a part
of this right to other persons. It is already explained in detail that
this right cannot be traded in, because it amounts to selling a
receivable debt at a discount which is one of the forms of riba
prohibited by the Holy Qur'an and Sunnah. Therefore, this concept
is not acceptable.
These are some basic features of the 'financial lease' which are
not in conformity with the dictates of Shari'ah. While using the
lease as an Islamic mode of finance, these shortcomings must be
avoided.
The list of the possible shortcomings in the lease agreement is
not restricted to what has been mentioned above, but only the basic
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MURABAHAH
errors found in different agreements have been pointed out, and the
basic principles of Islamic leasing have been summarized. An
Islamic lease agreement must conform to all of them.
127
7
Salam and Istisna
It is one of the basic conditions for the validity of a sale in Shari'ah
that the commodity (intended to be sold) must be in the physical or
constructive possession of the seller. This condition has three
ingredients:
Firstly, the commodity must be existing; therefore, a
commodity which does not exist at the time of sale cannot be sold.
Secondly, the seller should have acquired the ownership of that
commodity. Therefore, if the commodity is existing, but the seller
does not own it, he cannot sell it to anybody.
Thirdly, mere ownership is not enough. It should have come in
to the possession of the seller, either physically or constructively. If
the seller owns a commodity, but he has not taken its delivery
himself or through an agent, he cannot sell it.
There are only two exceptions to this general principle in
Shari'ah. One is salam and the other is istisna'. Both are sales of a
special nature, and in the present chapter the concept of these two
kinds of sale and the extent to which they can be used for the
purpose of financing will be explained.
Salam
Salam is a sale whereby the seller undertakes to supply some specific
goods to the buyer at a future date in exchange of an advanced price
fully paid at spot.
Here the price is cash, but the supply of the purchased goods is
deferred. The buyer is called " ' rabb-us-salam\ the seller is "muslam
ilaih" , the cash price is " ra's-ul-mal" and the purchased commodity
SALAM AND ISTISNA
is termed as "muslam fib", but for the purpose of simplicity, I shall
use the English synonyms of these terms.
Salam was allowed by the Holy Prophet #§1 subject to certain
conditions. The basic purpose of this sale was to meet the needs of
the small farmers who needed money to grow their crops and to
feed their family upto the time of harvest. After the prohibition of
riba they could not take usurious loans. Therefore, it was allowed
for them to sell the agricultural products in advance.
Similarly, the traders of Arabia used to export goods to other
places and to import some other goods to their homeland. They
needed money to undertake this type of business. They could not
borrow from the usurers after the prohibition of riba. It was,
therefore, allowed for them that they sell the goods in advance.
After receiving their cash price, they could easily undertake the
aforesaid business.
Salam was beneficial to the seller, because he received the price
in advance, and it was beneficial to the buyer also, because
normally, the price in salam used to be lower than the price in spot
sales. The permissibility of salam was an exception to the general
rule that prohibits the forward sales, and therefore, it was subjected
to some strict conditions. These conditions are summarized below:
Conditions of Salam
1. First of all, it is necessary for the validity of salam that the
buyer pays the price in full to the seller at the time of effecting the
sale. It is necessary because in the absence of full payment by the
buyer, it will be tantamount to sale of a debt against a debt, which is
expressly prohibited by the Holy Prophet jit. Moreover, the basic
wisdom behind the permissibility of salam is to fulfill the instant
needs of the seller. If the price is not paid to him in full, the basic
purpose of the transaction will be defeated. Therefore, all the
Muslim jurists are unanimous on the point that full payment of the
price is necessary in salam. However, Imam Malik is of the view
that the seller may give a concession of two or three days to the
buyers, but this concession should not form part of the agreement.
Ibn Qudamah, Al-Mughni, 4:328.
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AN INTRODUCTION TO ISLAMIC FINANCE
2. Salam can be effected in those commodities only the quality
and quantity of which can be specified exactly. The things whose
quality or quantity is not determined by specification cannot be sold
through the contract of salam. For example, precious stones cannot
be sold on the basis of salam, because every piece of precious stones
is normally different from the other either in its quality or in its size
or weight and their exact specification is not generally possible.
3. Salam cannot be effected on a particular commodity or on a
product of a particular field or farm. For example, if the seller
undertakes to supply the wheat of a particular field, or the fruit of a
particular tree, the salam will not be valid, because there is a
possibility that the crop of that particular field or the fruit of that
tree is destroyed before delivery, and, given such possibility, the
delivery remains uncertain. The same rule is applicable to every
commodity the supply of which is not certain.
4. It is necessary that the quality of the commodity (intended to
be purchased through salam) is fully specified leaving no ambiguity
which may lead to a dispute. All the possible details in this respect
must be expressly mentioned.
5. It is also necessary that the quantity of the commodity is
agreed upon in unequivocal terms. If the commodity is quantified
in weights according to the usage of its traders, its weight must be
determined, and if it is quantified through measures, its exact
measure should be known. What is normally weighed cannot be
quantified in measures and vice versa.
6. The exact date and place of delivery must be specified in the
contract.
7. Salam cannot be effected in respect of things which must be
delivered at spot. For example, if gold is purchased in exchange of
silver, it is necessary, according to Shari'ah, that the delivery of both
be simultaneous. Here, salam cannot work. Similarly, if wheat is
bartered for barley, the simultaneous delivery of both is necessary
for the validity of sale. Therefore the contract of salam in this case is
not allowed. All the Muslim jurists are unanimous on the principle
that salam will not be valid unless all these conditions are fully
observed, because they are based on the express ahadith of the Holy
2 See Ibn Qudamah, Al-Mughni (Riyadh, 1981), 4:325.
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SALAM AND ISTISNA
Prophet W$. The most famous hadith in this context is the one in
which the Holy Prophet j|| has said:
Whoever wishes to enter into a contract of salam, he must effect
the salam according to the specified measure and the specified
weight and the specified date of delivery. 3
However, there are certain other conditions which have been a
point of difference between the different schools of the Islamic
jurisprudence. Some of these conditions are discussed below:
(1) It is necessary, according to the Hanafi school, that the
commodity (for which salam is effected) remains available in the
market right from the day of contract upto the date of delivery.
Therefore, if a commodity is not available in the market at the time
of the contract, salam cannot be effected in respect of that
commodity, even though it is expected that it will be available in
the markets at the date of delivery.
However, the other three schools of Fiqh (i.e. Shafi'i, Maliki,
and Hanbali) are of the view that the availability of the commodity
at the time of the contract is not a condition for the validity of
salam. What is necessary, according to them, is that it should be
available at the time of delivery. 5
This view can be adopted in the present circumstances.
(2) It is necessary, according to the Hanafi and Hanbali schools
that the time of delivery is, at least, one month from the date of
agreement. If the time of delivery is fixed earlier than one month,
salam is not valid. Their argument is that salam has been allowed
for the needs of small farmers and traders and therefore, they should
be given enough opportunity to acquire the commodity. They may
not be able to supply the commodity before one month. Moreover,
3 This hadith is reported by all the six famous books of hadith (see Ibn al-
Hummam, Fat-h al-Qadir, 6:205).
AI-Kasani, BadaT al-Sana'l', 5:211.
5 Ibn Qudamah, AJ-Mughni, 4:326.
6 Ashraf 'Ali Thanawi, Imdad al-Fatawa, Vol. 3.
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the price in salam is normally lower than the price in spot sales.
This concession in the price may be justified only when the
commodities are delivered after a period which has a reasonable
bearing on the prices. A period of less than one month does not
normally affect the prices. Therefore, the minimum time of delivery
should not be less than one month. 7
Imam Malik supports the view that there should be a minimum
period for the contract of salam. However, he is of the opinion that
it should not be less than fifteen days, because the rates of the
market may change within a fortnight.
This view is, however, opposed by some other jurists, like Imam
Shafi'i and some Hanafi jurists also. 9 They say that the Holy
Prophet HI has not specified a minimum period for the validity of
salam. The only condition, according to the Hadith, is that the time
of delivery must be clearly defined. Therefore, no minimum period
can be prescribed. The parties may fix any date for delivery with
mutual consent.
This view seems to be preferable in the present circumstances,
because the Holy Prophet -i§ has not prescribed a minimum
period. The jurists have prescribed different periods which range
between one day to one month. It is obvious that they have done so
on the basis of expedience and keeping in view the interest of the
poor sellers. But the expediency may differ from time to time and
from place to place. Likewise, sometimes it is more in the interest of
the seller to fix an earlier date. As far as the price is concerned, it is
not a necessary ingredient of salam that the price is always lower
than the market price on that day. The seller himself is the best
judge of his interest, and if he accepts an earlier date of delivery with
his free will and consent, there is no reason why he should be
forbidden from doing so.
Certain contemporary jurists have adopted this view being more
suitable for the modern transactions. 10
7 Ibn Qudamah, Al-Mughni, 4:323.
8 AI-Dardir, Al-Sharh al-Saghir, 3:275; al-Khurashi, 3:20.
9 Ibn al-Hummam, Fat-h al-Qadir, 6:219.
10 Ashraf 'Ali Thanawi, Imdad al-Fatawa, Vol. 3.
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Salam as a Mode of Financing
It is evident from the foregoing discussion that salam was allowed
by Shari'ah to fulfill the needs of farmers and traders. Therefore, it
is basically a mode of financing for small farmers and traders. This
mode of financing can be used by the modern banks and financial
institutions, especially to finance the agricultural sector. As pointed
out earlier, the price in salam may be fixed at a lower rate than the
price of those commodities delivered at spot. In this way, the
difference between the two prices may be a valid profit for the banks
or financial institutions. In order to ensure that the seller shall
deliver the commodity on the agreed date, they can also ask him to
furnish a security, which may be in the form of a guarantee or in the
form of mortgage or hypothecation. In the case of default in
delivery, the guarantor may be asked to deliver the same
commodity, and if there is a mortgage, the buyer / the financier can
sell the mortgaged property and the sale proceeds can be used either
to realize the required commodity by purchasing it from the
market, or to recover the price advanced by him.
The only problem in salam which may agitate the modern
banks and financial institutions is that they will receive certain
commodities from their clients, and will not receive money. Being
conversant with dealing in money only, it seems to be cumbersome
for them to receive different commodities from different clients and
to sell them in the market. They cannot sell those commodities
before they are actually delivered to them, because it is prohibited in
Shari'ah.
But whenever we talk about the Islamic modes of financing, one
basic point should never be ignored. The point is that the concept
of the financial institutions dealing in money only is foreign to
Islamic Shari'ah. If these institutions want to earn a halal profit,
they shall have to deal in commodities in one way or the other,
because no profit is allowed in Shari'ah on advancing loans only.
Therefore, the establishment of an Islamic economy requires a basic
change in the approach and in the outlook of the financial
institutions. They shall have to establish a special cell for dealing in
commodities. If such a special cell is established, it should not be
11 Ashraf 'Ali Thanawi, Imdad al-Fatawa, Vol. 3.
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difficult to purchase commodities through salam and to sell them in
the spot markets.
However, there are two other ways of benefiting from the
contract of salam.
Firstly, after purchasing a commodity by way of salam, the
financial institutions may sell it through a parallel contract of salam
for the same date of delivery. The period of salam in the second
(parallel) transaction being shorter, the price may be a little higher
than the price of the first transaction, and the difference between
the two prices shall be the profit earned by the institution. The
shorter the period of salam, the higher the price, and the greater the
profit. In this way the institutions may manage their short term
financing portfolios.
Secondly, if a parallel contract of salam is not feasible for one
reason or another, they can obtain a promise to purchase from a
third party. This promise should be unilateral from the expected
buyer. Being merely a promise, and not the actual sale, their buyers
will not have to pay the price in advance. Therefore, a higher price
may be fixed and as soon as the commodity is received by the
institution, it will be sold to the third party at a pre-agreed price,
according to the terms of the promise.
A third option is sometimes proposed that, at the date of
delivery, the commodity is sold back to the seller at a higher price.
But this suggestion is not in line with the dictates of Shari'ah. It is
never permitted by the Shari'ah that the purchased commodity is
sold back to the seller before the buyer takes its delivery, and if it is
done at a higher price it will be tantamount to riba which is totally
prohibited. Even if it is sold back to the seller after taking delivery
from him, it cannot be pre-arranged at the time of original sale.
Therefore, this proposal is not acceptable at all.
Some Rules of Parallel Salam
Since the modern Islamic Banks and Financial Institutions are using
the instrument of parallel salam, some rules for the validity of this
arrangement are necessary to observe:
1. In an arrangement of parallel salam, the bank enters into two
different contracts. In one of them, the bank is the buyer and in the
second one the bank is the seller. Each one of these contracts must
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be independent of the other. They cannot be tied up in a manner
that the rights and obligations of one contract are dependant on the
rights and obligations of the parallel contract. Each contract should
have its own force and its performance should not be contingent on
the other.
For example, if A has purchased from B 1000 bags of wheat by
way of salam to be delivered on 3 1 December, A can contract a
parallel salam with C to deliver to him 1000 bags of wheat on 31
December. But while contracting parallel salam with C, the delivery
of wheat to C cannot be conditioned with taking delivery from B.
Therefore, even if B did not deliver wheat on 3 1 December, A is
duty bound to deliver 1000 bags of wheat to C. He can seek
whatever recourse he has against B, but he cannot rid himself from
his liability to deliver wheat to C.
Similarly, if B has delivered defective goods which do not
conform with the agreed specifications, A is still obligated to deliver
the goods to C according to the specifications agreed with him.
2. Parallel salam is allowed with a third party only. The seller in
the first contract cannot be made purchaser in the parallel contract
of salam, because it will be a buy-back contract, which is not
permissible in Shari'ah. Even if the purchaser in the second contract
is a separate legal entity, but it is fully owned by the seller in the
first contract the arrangement will not be allowed, because in
practical terms it will amount to 'buy-back' arrangement. For
example A has purchased 1 000 bags of wheat by way of salam from
B, a joint stock company. B has a subsidiary C, which is a separate
legal entity but is fully owned by B. A cannot contract the parallel
salam with C. However, if C is not wholly owned by B, A can
contract parallel salam with it, even if some share-holders are
common between B and C.
Istisna'
'Istisna' is the second kind of sale where a commodity is transacted
before it comes into existence. It means to order a manufacturer to
manufacture a specific commodity for the purchaser. If the
manufacturer undertakes to manufacture the goods for him with
material from the manufacturer, the transaction of istisna' comes
into existence. But it is necessary for the validity of istisna' that the
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price is fixed with the consent of the parties and that necessary
specification of the commodity (intended to be manufactured) is
fully settled between them.
The contract of istisna' creates a moral obligation on the
manufacturer to manufacture the goods, but before he starts the
work, any one of the parties may cancel the contract after giving a
notice to the other. However after the manufacturer has started
the work, the contract cannot be cancelled unilaterally.
Difference Between Istisna' and Salam
Keeping in view this nature of istisna' there are several points of
difference between istisna' and salam which are summarized below:
(i) The subject of istisna' is always a thing which needs
manufacturing, while salam can be effected on any thing, no matter
whether it needs manufacturing or not.
(ii) It is necessary for salam that the price is paid in full in
advance, while it is not necessary in istisna'.
(iii) The contract of salam, once effected, cannot be cancelled
unilaterally, while the contract of istisna' can be cancelled before the
manufacturer starts the work.
(iv) The time of delivery is an essential part of the sale in salam
while it is not necessary in istisna' that the time of delivery is
fixed. 13
Difference Between Istisna' and Ijarah
It should also be kept in mind that the manufacturer, in istisna',
undertakes to make the required goods with his own material.
Therefore, this transaction implies that the manufacturer shall
obtain the material, if it is not already with him, and shall
undertake the work required for making the ordered goods with it.
If the material is provided by the customer, and the manufacturer is
required to use his labor and skill only, the transaction is not
istisna'. In this case it will be a transaction of ijarah whereby the
services of a person are hired for a specified fee paid to him.
12 Ibn 'Abidin, Radd ' al-Muhcar, 5:223.
13 Ibid., 5:225.
14 Khalid al-Atasi, Sharh al-MajaJlah, 2:403.
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SALAM AND ISTISNA
When the required goods have been manufactured by the seller,
he should present them to the purchaser. But there is a difference of
opinion among the Muslim jurists whether or not the purchaser has
a right to reject the goods at this stage. Imam Abu Hanifah is of the
view that he can exercise his 'option of seeing' {khiyar-ur-ru'yah)
after seeing the goods, because istisna' is a sale and if somebody
purchases a thing which is not seen by him, he has the option to
cancel the sale after seeing it. The same principle is also applicable
to istisna'.
However, Imam Abu Yusuf says that if the commodity
conforms to the specifications agreed upon between the parties at
the time of the contract, the purchaser is bound to accept the goods
and he cannot exercise the option of seeing. This view has been
preferred by the jurists of the Ottoman Empire, and the Hanafi law
has been codified according to this view, because it is damaging in
the context of modern trade and industry that after the
manufacturer has used all his resources to prepare the required
goods, the purchaser cancels the sale without assigning any reason,
even though the goods are in full conformity with the required
specifications. 15
Time of Delivery
As pointed out earlier, it is not necessary in istisna' that the time of
delivery is fixed. However, the purchaser may fix a maximum time
for delivery which means that if the manufacturer delays the
delivery after the appointed time, he will not be bound to accept the
goods and to pay the price. 16
In order to ensure that the goods will be delivered within the
specified period, some modern agreements of this nature contain a
penal clause to the effect that in case the manufacturer delays the
delivery after the appointed time, he shall be liable to a penalty
which shall be calculated on daily basis. Can such a penal clause be
inserted in a contract of istisna' according to Shari'ah? Although the
classical jurists seem to be silent about this question while they
discuss the contract of istisna', yet they have allowed a similar
15 See Majallah, sec. 392 and the introduction.
16 Ibn 'Abidin, Radd ' al-Muhcar, 5:225.
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AN INTRODUCTION TO ISLAMIC FINANCE
condition in the case of ijarah. They say that if a person hires the
services of a person to tailor his clothes, the fee may be variable
according to the time of delivery. The hirer may say that he will pay
Rs. 100/- in case the tailor prepares the clothes within one day and
Rs. 80/- in case he prepares them after two days. 17
On the same analogy, the price in istisna' may be tied up with
the time of delivery, and it will be permissible if it is agreed between
the parties that in the case of delay in delivery, the price shall be
reduced by a specified amount per day.
Istisna' as a Mode of Financing
Istisna' can be used for providing the facility of financing in certain
transactions, especially in the house finance sector. If the client has
his own land and he seeks financing for the construction of a house,
the financier may undertake to construct the house at that open
land, on the basis of istisna', and if the client has no land and he
wants to purchase the land also, the financier may undertake to
provide him a constructed house on a specified piece of land.
Since it is not necessary in istisna' that the price is paid in
advance, nor is it necessary that it is paid at the time of delivery, (it
may be deferred to any time according to the agreement of the
parties) , therefore, the time of payment may be fixed in whatever
manner they wish. The payment may also be in installments.
On the other hand, it is not necessary that the financier himself
constructs the house. He can enter into a parallel contract of istisna'
with a third party, or may hire the services of a contractor (other
than the client). In both cases, he can calculate his cost and fix the
price of istisna' with his client in a manner which may give him a
reasonable profit over his cost. The payment of installments by the
client may start, in this case, right from the day when the contract
of istisna' is signed by the parties, and may continue during the
construction of the house and after it is handed over to the client.
In order to secure the payment of the installments, the title deeds of
the house or land, or any other property of the client may be kept
by the financier as a security, until the last installment is paid by the
client.
17 Ibid., 3:311.
18 Al-Atasi, Sharh al-Majallah, 2:406.
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The financier, in this case, will be responsible for the
construction of the house in full conformity with the specifications
detailed in the agreement. In the case of any discrepancy, the
financier will undertake such alteration at his own cost as may be
necessary for bringing it in harmony with the terms of the contract.
The instrument of istisna' may also be used for project financing
on similar lines. If a client wants to install an air-conditioning plant
in his factory, and the plant needs to be manufactured, the financier
may undertake to prepare the plant through the contract of istisna'
according to the aforesaid procedure. Similarly, the contract of
istisna' can be used for building a bridge or a highway.
The modern BOT (Buy, Operate and Transfer) agreements may
also be formalized on the basis of istisna'. If a government wants to
construct a highway, it may enter into a contract of istisna' with a
builder. The price of istisna', in this case, may be the right of the
builder to operate the highway and collect tolls for a specified
period.
139
8
Islamic Investment
Funds
The term "Islamic Investment Fund" in this chapter means a joint
pool wherein the investors contribute their surplus money for the
purpose of its investment to earn halal profits in strict conformity
with the precepts of Islamic Shari'ah. The subscribers of the Fund
may receive a document certifying their subscription and entitling
them to the pro-rata profits actually earned by the Fund. These
documents may be called 'certificates', 'units', 'shares' or may be
given any other name, but their validity in terms of Shari'ah, will
always be subject to two basic conditions:
Firstly, instead of a fixed return tied up with their face value,
they must carry a pro-rata profit actually earned by the Fund.
Therefore, neither the principal nor a rate of profit (tied up with the
principal) can be guaranteed. The subscribers must enter into the
fund with a clear understanding that the return on their
subscription is tied up with the actual profit earned or loss suffered
by the Fund. If the Fund earns huge profits, the return on their
subscription will increase to that proportion. However, in case the
Fund suffers loss, they will have to share it also, unless the loss is
caused by the negligence or mismanagement, in which case the
management, and not the Fund, will be liable to compensate it.
Secondly, the amounts so pooled together must be invested in a
business acceptable to Shari'ah. It means that not only the channels
of investment, but also the terms agreed with them must conform
to the Islamic principles.
ISLAMIC EQUITY FUNDS
Keeping these basic requisites in view, the Islamic Investment
Funds may accommodate a variety of modes of investment which
are discussed briefly in the following paragraphs
Equity Fund
In an equity fund the amounts are invested in the shares of joint
stock companies. The profits are mainly derived through the capital
gains by purchasing the shares and selling them when their prices
are increased. Profits are also earned through dividends distributed
by the relevant companies.
It is obvious that if the main business of a company is not lawful
in terms of Shari'ah, it is not allowed for an Islamic Fund to
purchase, hold or sell its shares, because it will entail the direct
involvement of the share holder in that prohibited business.
Similarly the contemporary Shari'ah experts are almost
unanimous on the point that if all the transactions of a company are
in full conformity with Shari'ah, which includes that the company
neither borrows money on interest nor keeps its surplus in an
interest bearing account, its shares can be purchased, held and sold
without any hindrance from the Shari'ah side. But evidently, such
companies are very rare in the contemporary stock markets. Almost
all the companies quoted in the present stock markets are in some
way involved in an activity which violates the injunctions of
Shari'ah. Even if the main business of a company is halal, its
borrowings are based on interest'. On the other hand, they keep
their surplus money in an interest bearing account or purchase
interest-bearing bonds or securities.
The case of such companies has been a matter of debate
between the Shari'ah experts in the present century. A group of the
Shari'ah experts is of the view that it is not allowed for a Muslim to
deal in the shares of such a company, even if its main business is
halal. Their basic argument is that every share-holder of a company
is a shank (partner) of the company, and every sharik, according to
the Islamic jurisprudence, is an agent for the other partners in the
matters of the joint business. Therefore, the mere purchase of a
share of a company embodies an authorization from the share-
holder to the company to carry on its business in whatever manner
the management deems fit. If it is known to the share-holder that
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AN INTRODUCTION TO ISLAMIC FINANCE
the company is involved in an un-Islamic transaction, and still he
holds the shares of that company, it means that he has authorized
the management to proceed with that UN-Islamic transaction. In
this case, he will not only be responsible for giving his consent to an
UN-Islamic transaction, but that transaction will also be rightfully
attributed to himself, because the management of the company is
working under his tacit authorization.
Moreover, when a company is financed on the basis of interest,
its funds employed in the business are impure. Similarly, when the
company receives interest on its deposits an impure element is
necessarily included in its income which will be distributed to the
share-holders through dividends.
However, a large number of the present day scholars do not
endorse this view. They argue that a joint stock company is basically
different from a simple partnership. In partnership, all the policy
decisions are taken through the consensus of all the partners, and
each one of them has a veto power with regard to the policy of the
business. Therefore, all the actions of a partnership are rightfully
attributed to each partner. Conversely, the policy decisions in a
joint stock company are taken by the majority. Being composed of a
large number of share-holders, a company cannot give a veto power
to each share-holder. The opinions of individual share-holders can
be overruled by a majority decision. Therefore, each and every
action taken by the company cannot be attributed to every share-
holder in his individual capacity. If a share-holder raises an
objection against a particular transaction in an Annual General
Meeting, but his objection is overruled by the majority, it will not
be fair to conclude that he has given his consent to that transaction
in his individual capacity, especially when he intends to refrain from
the income resulting from that transaction.
Therefore, if a company is engaged in a halal business, but also
keeps its surplus money in an interest-bearing account, wherefrom a
small incidental income of interest is received, it does not render all
the business of the company unlawful. Now, if a person acquires the
shares of such a company with clear intention that he will oppose
this incidental transaction also, and will not use that proportion of
the dividend for his own benefit, how can it be said that he has
approved the transaction of interest and how can that transaction be
attributed to him?
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The other aspect of the dealings of such a company is that it
sometimes borrows money from financial institutions. These
borrowings are mostly based on interest. Here again the same
principle is relevant. If a share-holder is not personally agreeable to
such borrowings, but has been overruled by the majority, these
borrowing transactions cannot be attributed to him.
Moreover, even though according to the principles of Islamic
jurisprudence, borrowing on interest is a grave and sinful act, for
which the borrower is responsible in the Hereafter; but, this sinful
act does not render the whole business of the borrower as haram or
impermissible. The borrowed amount being recognized as owned
by the borrower, anything purchased in exchange for that money is
not unlawful. Therefore, the responsibility of committing a sinful
act of borrowing on interest rests with the person who willfully
indulged in a transaction of interest, but this fact does render the
whole business of a company as unlawful
Conditions for Investment in Shares
In the light of the foregoing discussion, dealing in equity shares can
be acceptable in Shari'ah subject to the following conditions:
1. The main business of the company is not violative of
Shari'ah. Therefore, it is not permissible to acquire the shares of the
companies providing financial services on interest, like conventional
banks, insurance companies, or the companies involved in some
other business not approved by the Shari'ah, such as companies
manufacturing, selling or offering liquors, pork, haram meat, or
involved in gambling, night club activities, pornography etc.
2. If the main business of the companies is halal, like
automobiles, textile, etc. but they deposit their surplus amounts in
an interest-bearing account or borrow money on interest, the share
holder must express his disapproval against such dealings, preferably
by raising his voice against such activities in the annual general
meeting of the company.
3. If some income from interest-bearing accounts is included in
the income of the company, the proportion of such income in the
dividend paid to the share-holder must be given in charity, and
must not be retained by him. For example, if 5% of the whole
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AN INTRODUCTION TO ISLAMIC FINANCE
income of a company has come out of interest-bearing deposits, 5%
of the dividend must be given in charity.
4. The shares of a company are negotiable only if the company
owns some illiquid assets. If all the assets of a company are in liquid
form, i.e. in the form of money they cannot be purchased or sold
except at par value, because in this case the share represents money
only and the money cannot be traded in except at par.
What should be the exact proportion of illquid assets of a
company for warranting the negotiability of its shares? The
contemporary scholars have different views about this question.
Some scholars are of the view that the ratio of illiquid assets must be
51% in the least. They argue that if such assets are less than 50%,
then most of the assets are in liquid form, and therefore, all its assets
should be treated as liquid on the basis of the juristic principle:
The majority deserves to be treated as the whole of a thing.
Some other scholars have opined that even if the illiquid asset of a
company are 33%, its shares can be treated as negotiable.
The third view is based on the Hanafi jurisprudence. The
principle of the Hanafi school is that whenever an asset is a
combination of liquid and illiquid assets, it can be negotiable
irrespective of the proportion of its liquid part. However, this
principle is subject to two conditions:
Firstly, the illiquid part of the combination must not be in
ignore-able quantity. It means that it should be in a considerable
proportion.
Secondly, the price of the combination should be more than the
value of the liquid amount contained therein. For example, if a
share of 100 dollars represents 75 dollars, plus some fixed assets, the
price of the share must be more than 75 dollars. In this case, if the
price of the share is fixed as 105, it will mean that 75 dollars are in
exchange of 75 dollars owned by the share and the balance of 30
dollars is in exchange of the fixed assets. Conversely, if the price of
that share is fixed as 70 dollars, it will not be allowed, because the
75 dollars owned by the share are in this case against an amount
which is less than 75. This kind of exchange falls within the
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ISLAMIC EQUITY FUNDS
definition of 'riba' and is not allowed. Similarly, if the price of the
share, in the above example, is fixed as 75 dollars, it will not be
permissible, because if we presume that 75 dollars of the price are
against 75 dollars owned by the share, no part of the price can be
attributed to the fixed assets owned by the share. Therefore, some
part of the price (75 dollars) must be presumed to be in exchange of
the fixed assets of the share. In this case, the remaining amount will
not be adequate for being the price of 75 dollars. For this reason the
transaction will not be valid. However, in practical terms, this is
merely a theoretical possibility, because it is difficult to imagine a
situation where the price of a share goes lower than its liquid assets.
Subject to these conditions, the purchase and sale of shares is
permissible in Shari'ah. An Islamic Equity Fund can be established
on this basis. The subscribers to the Fund will be treated in Shari'ah
as partners inter se. All the subscription amounts will form a joint
pool and will be invested in purchasing the shares of different
companies. The profits can accrue either through dividends
distributed by the relevant companies or through the appreciation
in the prices of the shares. In the first case i.e. where the profits are
earned through dividends, a certain proportion of the dividend,
which corresponds to the proportion of interest earned by the
company, must be given in charity. The contemporary Islamic
Funds have termed this process as 'purification'.
The Shari'ah scholars have different views about whether the
'purification' is necessary where the profits are made through capital
gains (i.e. by purchasing the shares at a lower price and selling them
at a higher price). Some scholars are of the view that even in the
case of capital gains, the process of 'purification' is necessary,
because the market price of the share may reflect an element of
interest included in the assets of the company. The other view is
that no purification is required if the share is sold, even if it results
in a capital gain. The reason is that no specific amount of the price
can be allocated for the interest received by the company. It is
obvious that if all the above requirements of the halal shares are
observed, then most of the assets of the company are halal, and a
very small proportion of its assets may have been created by the
income of interest. This small proportion is not only unknown, but
also ignore- able as compared to bulk of the assets of the company.
Therefore, the price of the share, in fact, is against bulk of the assets,
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AN INTRODUCTION TO ISLAMIC FINANCE
and not against such a small proportion. The whole price of the
share therefore, may be taken as the price of the halal assets only.
Although this second view is not without force, yet the first view
is more precautious and far from doubts. Particularly, it is more
equitable in an open-ended equity fund, because if the purification
is not carried out on the appreciation and a person redeems his unit
of the Fund at a time when no dividend is received by it, no
amount of purification will be deducted from its price, even though
the price of the unit may have increased due to the appreciation in
the prices of the shares held by the fund. Conversely, when a person
redeems his unit after some dividends have been received in the
fund and the amount of purification has been deducted therefrom,
reducing the net asset value per unit, he will get a lesser price as
compared to the first person.
On the contrary, if purification is carried out both on dividends
and on capital gains, all the unit-holders will be treated at par with
regard to the deduction of the amounts of purification. Therefore, it
is not only free from doubts but also more equitable for all the unit-
holders to carry out purification in the capital gains also. This
purification may be carried out on the basis of an average
percentage of the interest earned by the companies included in the
portfolio.
The management of the fund may be carried out in two
alternative ways. The managers of the Fund may act as mudaribs for
the subscribers. In this case a certain percentage of the annual profit
accrued to the Fund may be determined as the reward of the
management, meaning thereby that the management will get its
share only if the fund has earned some profit. If there is no profit in
the fund, the management will deserve nothing. The share of the
management will increase with the increase of profits.
The second option for the management is to act as an agent for
the subscribers. In this case, the management may be given a pre-
agreed fee for its services. This fee may be fixed in lump sum or as a
monthly or annual remuneration. According to the contemporary
Shari'ah scholars, the fee can also be based on a percentage of the
net asset value of the fund. For example, it may be agreed that the
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ISLAMIC EQUITY FUNDS
management will get 2% or 3% of the net asset value of the fund 1
at the end of every financial year.
However, it is necessary in Shari'ah to determine any one of the
aforesaid methods before the launch of the fund. The practical way
for this would be to disclose in the prospectus of the fund the basis
on which the fees of the management will be paid. It is generally
presumed that whoever subscribes to the fund agrees with the terms
mentioned in the prospectus. Therefore, the manner of paying the
management will be taken as agreed upon by all the subscribers.
Ijarah Fund
Another type of Islamic Fund may be an ijarah fund. Ijarah means
leasing the detailed rules of which have already been discussed in the
third chapter of this book. In this fund the subscription amounts
are used to purchase assets like real estate, motor vehicles or other
equipment for the purpose of leasing them out to their ultimate
users. The ownership of these assets remains with the Fund and the
rentals are charged from the users. These rentals are the source of
income for the fund which is distributed pro rata to the subscribers.
Each subscriber is given a certificate to evidence his
proportionate ownership in the leased assets and to ensure his
entitlement to the pro rata share in the income. These certificates
may preferably be called 'sukuk' — a term recognized in the
traditional Islamic jurisprudence. Since these sukuk represent the
pro rata ownership of their holders in the tangible assets of the
fund, and not the liquid amounts or debts, they are fully negotiable
and can be sold and purchased in the secondary market. Anyone
who purchases these sukuk replaces the sellers in the pro rata
ownership of the relevant assets and all the rights and obligations of
the original subscriber are passed on to him. The price of these
sukuk will be determined on the basis of market forces, and are
normally based on their profitability.
However, it should be kept in mind that the contracts of leasing
must conform to the principles of Shari'ah which substantially differ
from the terms and conditions used in the agreements of
1 This way may be justified on the analogy of simsir (broker) for whom the fee
based on percentage is allowed.
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AN INTRODUCTION TO ISLAMIC FINANCE
conventional financial leases. The points of difference are explained
in detail in the third chapter of this book. However, some basic
principles are summarized here:
1. The leased assets must have some usufruct, and the rental
must be charged only from that point of time when the usufruct is
handed over to the lessee.
2. The leased assets must be of a nature that their halal
(permissible) use is possible.
3. The lessor must undertake all the responsibilities consequent
to the ownership of the assets.
4. The rental must be fixed and known to the parties right at
the beginning of the contract.
In this type of the fund the management should act as an agent
of the subscribers and should be paid a fee for its services. The
management fee may be a fixed amount or a proportion of the
rentals received. Most of the Muslim jurists are of the view that
such a fund cannot be created on the basis of mudarabah, because
mudarabah, according to them, is restricted to the sale of
commodities and does not extend to the business of services and
leases. However, in the Hanbali school, mudarabah can be effected
in services and leases also. This view has been preferred by a number
of contemporary scholars.
Commodity Fund
Another possible type of Islamic Funds may be a commodity fund.
In the fund of this type the subscription amounts are used in
purchasing different commodities for the purpose of their resale.
The profits generated by the sales are the income of the fund which
is distributed pro rata among the subscribers.
In order to make this fund acceptable to Shari'ah, it is necessary
that all the rules governing the transactions of sale are fully
complied with. For example:
1. The commodity must be owned by the seller at the time of
sale, because short sales in which a person sells a commodity before
he owns it are not allowed in Shari'ah.
2. Forward sales are not allowed except in the case of salam and
istisna' (For their full details the previous chapter of this book may
be consulted).
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ISLAMIC EQUITY FUNDS
3. The commodities must be halal. Therefore, it is not allowed
to deal in wines, pork or other prohibited materials.
4. The seller must have physical or constructive possession over
the commodity he wants to sell. (Constructive possession includes
any act by which the risk of the commodity is passed on to the
purchaser) .
5. The price of the commodity must be fixed and known to the
parties. Any price which is uncertain or is tied up with an uncertain
event renders the sale invalid.
In view of the above and similar other conditions, more fully
described in the second chapter of this book, it may easily be
understood that the transactions prevalent in the contemporary
commodity markets, specially in the futures commodity markets do
not comply with these conditions. Therefore, an Islamic
Commodity Fund cannot enter into such transactions. However, if
there are genuine commodity transactions observing all the
requirements of Shari'ah, including the above conditions, a
commodity fund may well be established. The units of such a fund
can also be traded in with the condition that the portfolio owns
some commodities at all times.
MURABAHAH FUND
Murabahah is a specific kind of sale where the commodities are sold
on a cost-plus basis. This kind of sale has been adopted by the
contemporary Islamic banks and financial institutions as a mode of
financing. They purchase the commodity for the benefit of their
clients, then sell it to them on the basis of deferred payment at an
agreed margin of profit added to the cost. If a fund is created to
undertake this kind of sale, it should be a closed-end fund and its
units cannot be negotiable in a secondary market. The reason is that
in the case of murabahah, as undertaken by the present financial
institutions, the commodities are sold to the clients immediately
after their purchase from the original supplier, while the price being
on deferred payment basis becomes a debt payable by the client.
Therefore, the portfolio of murabahah does not own any tangible
assets. It comprises either cash or the receivable debts, Therefore,
the units of the fund represent either the money or the receivable
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AN INTRODUCTION TO ISLAMIC FINANCE
debts, and both these things are not negotiable, as explained earlier.
If they are exchanged for money, it must be at par value.
Bai'-Al-Dain
Here comes the question whether or not bai'-al-dain is allowed in
Shari'ah. Dain means 'debt' and bai' means sale. Bai'-al-dain,
therefore, connotes the sale of debt. If a person has a debt receivable
from a person and he wants to sell it at a discount, as normally
happens in the bills of exchange, it is termed in Shari'ah as Bai'-al-
dain. The traditional Muslim jurists (fuqaha') are unanimous on the
point that bai'al-dain with discount is not allowed in Shari'ah. The
overwhelming majority of the contemporary Muslim scholars are of
the same view. However, some scholars of Malaysia have allowed
this kind of sale. They normally refer to the ruling of Shafi'ite
school wherein it is held that the sale of debt is allowed, but they
did not pay attention to the fact that the Shafi'ite jurists have
allowed it only in a case where a debt is sold at its par value.
In fact, the prohibition of bai'-al-dain is a logical consequence
of the prohibition of 'riba' or interest. A 'debt' receivable in
monetary terms corresponds to money, and every transaction where
money is exchanged for the same denomination of money, the price
must be at par value. Any increase or decrease from one side is
tantamount to 'riba' and can never be allowed in Shari'ah.
Some scholars argue that the permissibility of bai'-al-dain is
restricted to a case where the debt is created through the sale of a
commodity. In this case, they say, the debt represents the sold
commodity and its sale may be taken as the sale of a commodity.
The argument, however, is devoid of force. For, once the
commodity is sold, its ownership is passed on to the purchaser and
it is no longer owned by the seller. What the seller owns is nothing
other than money. Therefore if he sells the debt, it is no more than
the sale of money and it cannot be termed by any stretch of
imagination as the sale of the commodity.
That is why this view has not been accepted by the
overwhelming majority of the contemporary scholars. The Islamic
Fiqh Academy of Jeddah, which is the largest representative body of
the Shari'ah scholars and has the representation of all the Muslim
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ISLAMIC EQUITY FUNDS
countries, including Malaysia, has approved the prohibition of bai'-
al-dain unanimously without a single dissent.
Mixed Fund
Another type of Islamic Fund may be of a nature where the
subscription amounts are employed in different types of
investments, like equities, leasing, commodities etc. This may be
called a Mixed Islamic Fund. In this case if the tangible assets of the
Fund are more than 5 1 % while the liquidity and debts are less than
50% the units of the fund may be negotiable. However, if the
proportion of liquidity and debts exceeds 50%, its units cannot be
traded according to the majority of the contemporary scholars. In
this case the Fund must be a closed-end Fund.
151
9
The Principle of
Limited Liability
The concept of 'limited liability' has now become an inseparable
ingredient of the large scale enterprises of trade and industry
throughout the modern world, including the Muslim countries.
The present chapter aims to explain this concept and evaluate it
from the Shari'ah point of view in order to know whether or not
this principle is acceptable in a pure Islamic economy. The limited
liability' in the modern economic and legal terminology is a
condition under which a partner or a shareholder of a business
secures himself from bearing a loss greater than the amount he has
invested in a company or partner-ship with limited liability. If the
business incurs a loss, the maximum a shareholder can suffer, is that
he may lose his entire original investment. But the loss cannot
extend to his personal assets, and if the assets of the company are
not sufficient to discharge all its liabilities, the creditors cannot
claim the remaining part of their receivables from the personal assets
of the shareholders.
Although the concept of 'limited liability' was, in some
countries applied to the partnership also, yet, it was most commonly
applied to the companies and corporate bodies. Rather, it will be
more true, perhaps, to say that the concept of 'limited liability'
originally emerged with the emergence of the corporate bodies and
joint stock companies. The basic purpose of the introduction of this
principle was to attract the maximum number of investors to the
large-scale joint ventures and to assure them that their personal
THE PRINCIPLE OF LIMITED LIABILITY
fortunes will not be at stake if they wish to invest their savings in
such a joint enterprise. In the practice of modern trade, the concept
proved itself to be a vital force to mobilize large amounts of capital
from a wide range of investors.
No doubt, the concept of 'limited liability' is beneficial to the
shareholders of a company. But, at the same time, it may be
injurious to its creditors. If the liabilities of a limited company
exceed its assets, the company becomes insolvent and is
consequently liquidated, the creditors may lose a considerable
amount of their claims, because they can only receive the liquidated
value of the assets of the company, and have no recourse to its
shareholders for the rest of their claims. Even the directors of the
company who may be responsible for such an unfortunate situation
cannot be held responsible for satisfying the claims of the creditors.
It is this aspect of the concept of 'limited liability' which requires
consideration and research from the Shari'ah viewpoint.
Although the concept of 'limited liability' in the context of the
modern commercial practice is a new concept and finds no express
mention as such in the original sources of Islamic Fiqh, yet the
Shari'ah viewpoint about it can be sought in the principles laid
down by the Holy Qur'an, the Sunnah of the Holy Prophet <|§ and
the Islamic jurisprudence. This exercise requires some sort of ijtihad
carried out by the persons qualified for it. This ijtihad should
preferably be undertaken by the Shari'ah scholars at a collective
level, yet, as a pre-requisite, there should be some individual efforts
which may serve as a basis for the collective exercise.
As a humble student of Shari'ah, this author have been
considering the issue since long, and what is going to be presented
in this article should not be treated as a final verdict on this subject,
nor an absolute opinion on the point. It is the outcome of initial
thinking on the subject, and the purpose of this article is to provide
a foundation for further research.
The question of 'limited liability' it can be said, is closely related
to the concept of juridical personality of the modern corporate
bodies. According to this concept, a joint-stock company in itself
enjoys the status of a separate entity as distinguished from the
individual entities of its shareholders. The separate entity as a Active
person has legal personality and may thus sue and be sued, may
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AN INTRODUCTION TO ISLAMIC FINANCE
make contracts, may hold property in its name, and has the legal
status of a natural person in all its transactions entered into in the
capacity of a juridical person.
The basic question, it is believed, is whether the concept of a
'juridical person' is acceptable in Shari'ah or not. Once the concept
of 'juridical person' is accepted and it is admitted that, despite its
fictive nature, a juridical person can be treated as a natural person in
respect of the legal consequences of the transactions made in its
name, we will have to accept the concept of 'limited liability' which
will follow as a logical result of the former concept. The reason is
obvious. If a real person i.e. a human being dies insolvent, his
creditors have no claim except to the extent of the assets he has left
behind. If his liabilities exceed his assets, the creditors will certainly
suffer, no remedy being left for them after the death of the indebted
person.
Now, if we accept that a company, in its capacity of a juridical
person, has the rights and obligations similar to those of a natural
person, the same principle will apply to an insolvent company. A
company, after becoming insolvent, is bound to be liquidated: and
the liquidation of a company corresponds to the death of a person,
because a company after its liquidation, cannot exist any more. If
the creditors of a real person can suffer, when he dies insolvent, the
creditors of a juridical person may suffer too, when its legal life
comes to an end by its liquidation.
Therefore, the basic question is whether or not the concept of
'juridical person' is acceptable to Shari'ah. Although the idea of a
juridical person, as envisaged by the modern economic and legal
systems has not been dealt with in the Islamic Fiqh, yet there are
certain prcedents wherefrom the basic concept of a juridical person
may be derived by inference.
Waqf
The first precedent is that of a Waqf. The Waqf is a legal and
religious institution wherein a person dedicates some of his
properties for a religious or a charitable purpose. The properties,
after being declared as Waqf, no longer remain in the ownership of
the donor. The beneficiaries of a Waqf can benefit from the corpus
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THE PRINCIPLE OF LIMITED LIABILITY
or the proceeds of the dedicated property, but they are not its
owners. Its ownership vests in Allah Almighty alone.
It seems that the Muslim jurists have treated the Waqf as a
separate legal entity and have ascribed to it some characteristics
similar to those of a natural person. This will be clear from two
rulings given by the fuqaha' (Muslim jurists) in respect of Waqf.
Firstly, if a property is purchased with the income of a Waqf,
the purchased property cannot become a part of the Waqf
automatically. Rather, the jurists say, the property so purchased
shall be treated as a property owned by the Waqf. It clearly means
that a Waqf, like a natural person, can own a property.
Secondly, the jurists have clearly mentioned that the money
given to a mosque as donation does not form part of the Waqf, but
it passes to the ownership of the mosque.
Here again the mosque is accepted to be an owner of money.
This principle has been expressly mentioned by some jurists of the
Maliki school also. They have stated that a mosque is capable of
being the owner of something. This capability of the mosque,
according to them, is constructive, while the capability enjoyed by a
human being is physical.
Another renowned Maliki jurist, namely, Ahmad Al-Dardir,
validates a bequest made in favour of a mosque, and gives the reason
that a mosque can own properties. Not only this, he extends the
principle to an inn and a bridge also, provided that they are Waqf.
It is clear from these examples that the Muslim jurists have
accepted that a Waqf can own properties. Obviously, a Waqf is not
a human being, yet they have treated it as a human being in the
matter of ownership. Once its ownership it established, it will
logically follow that it can sell and purchase, may become a debtor
and a creditor and can sue and be sued, and thus all the
characteristics of a 'juridical person' can be attributed to it.
Baitul-Mal
Another example of 'juridical person' found in our classic literature
of Fiqh is that of the Baitul-mal (the exchequer of an Islamic state) .
1 AI-Fatawa al-Hindiyyah, Waqf, Ch. 5, 2:417
2 Ibid., 3:240. See also I'la" al-Sunan, 13:198.
3
See al-Khurashi's commentary on Mukhtasar al-Khalil, 7:80.
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AN INTRODUCTION TO ISLAMIC FINANCE
Being public property, all the citizens of an Islamic state have some
beneficial right over the Baitul-mal, yet, nobody can claim to be its
owner. Still, the Baitul-mal has some rights and obligations. Imam
Al-Sarakhsi, the well-known Hanafi jurist, says in his work "Al-
Mabsut":
The Baitul-mal has some rights and obligations which may
possibly be undetermined.
At another place the same author says:
If the head of an Islamic state needs money to give salaries to his
army, but he finds no money in the Kharaj department of the
Baitul-mal (wherefrom the salaries are generally given) he can give
salaries from the sadaqah (Zakah) department, but the amount so
taken from the sadaqah department shall be deemed to be a debt
on the Kharaj department. 5
It follows from this that not only the Baitul-mal, but also the
different departments therein can borrow and advance loans to each
other. The liability of these loans does not lie on the head of state,
but on the concerned department of Baitul-mal. It means that each
department of Baitul-mal is a separate entity and in that capacity it
can advance and borrow money, may be treated a debtor or a
creditor, and thus can sue and be sued in the same manner as a
juridical person does. It means that the Fuqaha of Islam have
accepted the concept of juridical person in respect of Baitul-mal.
Joint Stock
Another example very much close to the concept of 'juridical
person' in a joint stock company is found in the Fiqh of Imam
Shafi'i. According to a settled principle of Shafi'i School, if more
than one person run their business in partner-ship, where their
assets are mixed with each other, the zakah will be levied on each of
them individually, but it will be payable on their joint-stock as a
whole, so much so that even if one of them does not own the
4 Al-Sarakhsi, al-Mabsut, 14:33.
'Ibid., 3:18.
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THE PRINCIPLE OF LIMITED LIABILITY
amount of the nisab, but the combined value of the total assets
exceeds the prescribed limit of the nisab, zakah will be payable on
the whole joint-stock including the share of the former, and thus
the person whose share is less than the nisab shall also contribute to
the levy in proportion to his ownership in the total assets, whereas
he was not subject to the levy of zakah, had it been levied on each
person in his individual capacity.
The same principle, which is called the principle of ' ' Khultah-al-
Shuyu' is more forcefully applied to the levy of Zakah on the
livestock. Consequently, a person sometimes has to pay more Zakah
than he was liable to in his individual capacity, and sometimes he
has to pay less than that.
That is why the Holy Prophet 5|t has said:
'The separate assets should not be joined together nor the joint
assets should be separated in order to reduce the amount of
Zakah levied on them.
This principle of 'Khultah-al-Shuyu" which is also accepted to
some extent by the Maliki and Hanbali schools with some variance
in details, has a basic concept of a juridical person underlying it. It
is not the individual, according to this principle, who is liable to
Zakah. It is the 'joint-stock' which has been made subject to the
levy. It means that the 'joint-stock' has been treated a separate
entity, and the obligation of 'zakah has been diverted towards this
entity which is very close to the concept of a 'juridical person',
though it is not exactly the same.
Inheritance under Debt
The fourth example is the property left by a deceased person whose
liabilities exceed the value of all the property left by him. For the
purpose of brevity we can refer to it as 'inheritance under debt'.
According to the jurists, this property is neither owned by the
deceased, because he is no more alive, nor is it owned by his heirs,
for the debts on the deceased have a preferential right over the
property as compared to the rights of the heirs. It is not even owned
by the creditors, because the settlement has not yet taken place.
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AN INTRODUCTION TO ISLAMIC FINANCE
They have their claims over it, but it is not their property unless it is
actually divided between them. Being property of nobody, it has its
own existence and it can be termed a legal entity. The heirs of the
deceased or his nominated executor will look after the property as
managers, but they are not the owners. If the process of the
settlement of debt requires some expenses, the same will be met by
the property itself.
Looked at from this angle, this 'inheritance under debt' has its
own entity which may sell and purchase, becomes debtor and
creditor, and has the characteristics very much similar to those of a
'juridical person.' Not only this, the liability of this 'juridical
person' is certainly limited to its existing assets. If the assets do not
suffice to settle all the debts, there is no remedy left with its
creditors to sue anybody, including the heirs of the deceased, for the
rest of their claims.
These are some instances where the Muslim jurists have
affirmed a legal entity, similar to that of a juridical person. These
examples would show that the concept of 'juridical person' is not
totally foreign to the Islamic jurisprudence, and if the juridical
entity of a joint-stock company is accepted on the basis of these
precedents, no serious objection is likely to be raised against it.
As mentioned earlier, the question of limited liability of a
company is closely related to the concept of a 'juridical person'. If a
'juridical person' can be treated a natural person in its rights and
obligations, then, every person is liable only to the limit of the assets
he owns, and in case he dies insolvent no other person can bear the
burden of his remaining liabilities, however closely related to him he
may be. On this analogy the limited liability of a joint-stock
company may be justified.
The Limited Liability of the Master of a Slave
Here I would like to cite another example with advantage, which is
the closest example to the limited liability of a joint-stock company.
The example relates to a period of our past history when slavery was
in vogue, and the slaves were treated as the property of their masters
and were freely traded in. Although the institution of slavery with
reference to our age is something past and closed, yet the legal
principles laid down by our jurists while dealing with various
158
THE PRINCIPLE OF LIMITED LIABILITY
questions pertaining to the trade of slaves are still beneficial to a
student of Islamic jurisprudence, and we can avail of those
principles while seeking solutions to our modern problems and in
this respect, it is believed that this example is the most relevant to
the question at issue. The slaves in those days were of two kinds.
The first kind was of those who were not permitted by their masters
to enter into any commercial transaction. A slave of this kind was
called 'qinri '. But there was another kind of slaves who were allowed
by their masters to trade. A slave of this kind was called J ^Wf^BCh
The initial capital for the purpose of trade was given to such a slave
by his master, but he was free to enter into all the commercial
transactions. The capital invested by him totally belonged to his
master. The income would also vest in him, and whatever the slave
earned would go to the master as his exclusive property. If in the
course of trade, the slave incurred debts, the same would be set off
by the cash and the stock present in the hands of the slave. But if
the amount of such cash and stock would not be sufficient to set off
the debts, the creditors had a right to sell the slave and settle their
claims out of his price. However, if their claims would not be
satisfied even after selling the slave, and the slave would die in that
state of indebtedness, the creditors could not approach his master
for the rest of their claims.
Here, the master was actually the owner of the whole business,
the slave being merely an intermediary tool to carry out the business
transactions. The slave owned nothing from the business. Still, the
liability of the master was limited to the capital he invested
including the value of the slave. After the death of the slave, the
creditors could not have a claim over the personal assets of the
master.
This is the nearest example found in the Islamic Fiqh which is
very much similar to the limited liability of the share holders of a
company, which can be justified on the same analogy. On the basis
of these five precedents, it seems that the concepts of a juridical
person and that of limited liability do not contravene any
injunction of Islam. But at the same time, it should be emphasized,
that the concept of 'limited liability' should not be allowed to work
for cheating people and escaping the natural liabilities consequent
to a profitable trade. So, the concept could be restricted, to the
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AN INTRODUCTION TO ISLAMIC FINANCE
public companies only who issue their shares to the general public
and the number of whose shareholders is so large that each one of
them cannot be held responsible for the day-to-day affairs of the
business and for the debts exceeding the assets.
As for the private companies or the partnerships, the concept of
limited liability should not be applied to them, because, practically,
each one of their shareholders and partners can easily acquire a
knowledge of the day-to-day affairs of the business and should be
held responsible for all its liabilities. There may be an exception for
the sleeping partners or the shareholders of a private company who
do not take part in the business practically and their liability may be
limited as per agreement between the partners. If the sleeping
partners have a limited liability under this agreement, it means, in
terms of Islamic jurisprudence, that they have not allowed the
working partners to incur debts exceeding the value of the assets of
the business. In this case, if the debts of the business increase from
the specified limit, it will be the sole responsibility of the working
partners who have exceeded the limit.
The upshot of the foregoing discussion is that the concept of
limited liability can be justified, from the Shari'ah viewpoint, in the
public joint-stock companies and those corporate bodies only who
issue their shares to general public. The concept may also be applied
to the sleeping partners of a firm and to the shareholders of a private
company who take no active part in the business management. But
the liability of the active partners in a partnership and active
shareholders of a private company should always be unlimited.
At the end, we should again recall what has been pointed out at
the outset. The issue of limited liability, being a modern issue which
requires a collective effort to find out its solution in the light of
Shari'ah, the above discussion should not be deemed to be a final
verdict on the subject. This is only the outcome of an initial
thinking which always remains subject to further study and
research.
160
IO
The Performance of
the Islamic Banks —
A Realistic Evaluation
Islamic banking has become today an undeniable reality. The
number of Islamic banks and the financial institutions is ever
increasing. New Islamic Banks with huge amount of capital are
being established. Conventional banks are opening Islamic windows
or Islamic subsidiaries for the operations of Islamic banking. Even
the non-Muslim financial institutions are entering the field and
trying to compete each other to attract as many Muslim customers
as they can. It seems that the size of Islamic banking will be at least
multiplied during the next decade and the operation of Islamic
banks are expected to cover a large area of financial transactions of
the world. But before the Islamic financial institutions expand their
business they should evaluate their performance during the last two
decades because every new system has to learn from the experience
of the past, to revise its activities and to analyze its deficiencies in a
realistic manner. Unless we analyze our merits and demerits we
cannot expect to advance towards our total success. It is in this
perspective that we should seek to analyze the operation of Islamic
banks and financial institutions in the light of Shari'ah and to
highlight what they have achieved and what they have missed.
Once during a press conference in Malaysia, this author was
asked the question about the contribution of the Islamic Banks in
AN INTRODUCTION TO ISLAMIC FINANCE
promoting the Islamic economy. My reply to the question was
apparently contradictory, I said it he has contributed a lot and they
have contributed nothing. In the present chapter an attempt has
been made to elaborate upon this reply. When it was said that they
have contributed a lot, what was meant is that it was a remarkable
achievement of the Islamic banks that they have made a great break-
through in the present banking system by establishing Islamic
financial institutions meant to follow Shari'ah. It was a cherished
dream of the Muslim Ummah to have an interest-free economy, but
the concept of Islamic banking was merely a theory discussed in
research papers, having no practical example. It was the Islamic
banks and financial institutions which translated the theory into
practice and presented a living and practical example for the
theoretical concept in an environment where it was claimed that no
financial institution can work without interest. It was indeed a
courageous step on the part of the Islamic banks to come forward
with a firm resolution that all their transactions will conform to
Shari'ah and all their activities will be free from all transactions
involving interest.
Another major contribution of the Islamic banks is that, being
under supervision of their respective Shari'ah Boards they presented
a wide spectrum of questions relating to modern business, to the
Shari'ah scholars, thus providing them with an opportunity not
only to understand the contemporary practice of business and trade
but also to evaluate it in the light of Shari'ah and to find out other
alternatives which may be acceptable according to the Islamic
principles.
It must be understood that when we claim that Islam has a
satisfactory solution for every problem emerging in any situation in
all times to come, we do not mean that the Holy Qur'an or the
Sunnah of the Holy Prophet 3§§ or the rulings of the Islamic
scholars provide a specific answer to each and every minute detail of
our socio-economic life. What we mean is that the Holy Qur'an
and the Holy Sunnah of the Prophet |j| have laid down broad
principles in the light of which the scholars of every time have
deduced specific answers to the new situation arising in their age.
Therefore, in order to reach a definite answer about a new situation
the scholars of Shari'ah have to play a very important role. They
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THE PERFORMANCE OF THE ISLAMIC BANKS - A REALISTIC EVALUATION
have to analyze every new question in the light of the principles laid
down by the Holy Qur'an and Sunnah as well as in the light of the
standards set by the earlier jurists, enumerated in the books of
Islamic jurisprudence. This exercise is called istinbat or ijtihad. It is
this exercise which has enriched the Islamic jurisprudence with a
wealth of knowledge and wisdom for which no parallel is found in
any other religion. In a society where the Shari'ah is implemented in
its full sway the ongoing process of istinbat keeps injecting new
ideas, concepts and rulings into the heritage of Islamic
jurisprudence which makes it easier to find out specific answer to
almost every situation in the books of Islamic jurisprudence. But
during the past few centuries the political decline of the Muslims
stopped this process to a considerable extent. Most of the Islamic
countries were captured by non-Muslim rulers who by enforcing
with power the secular system of government, deprived the socio-
economic life from the guidance provided by the Shari'ah, and the
Islamic teachings were restricted to a limited sphere of worship,
religious education and in some countries to the matter of marriage,
divorce and inheritance only. So far as the political and economic
activities are concerned the governance of Shari'ah was totally
rejected.
Since the evolution of any legal system depends on its practical
application, the evolution of Islamic law with regard to business and
trade was hindered by this situation. Almost all the transactions in
the market being based on secular concepts were seldom brought to
the Shari'ah scholars for their scrutiny in the light of Shari'ah. It is
true that even in these days some practicing Muslims brought some
practical questions before the Shari'ah scholars for which the
scholars have been giving their rulings in the forms of fatawas of
which a substantial collection is still available. However, all these
fatawas related mostly to the individual problems of the relevant
persons and addressed their individual needs.
It is a major contribution of the Islamic banks that, because of
their entry into the field of large scale business, the wheel of
evolution of Islamic legal system has re-started. Most of the Islamic
banks are working under the supervision of their Shari'ah Boards.
They bring their day to day problems before the Shari'ah scholars
who examine them in the light of Islamic rules and principles and
give specific rulings about them. This procedure not only makes
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AN INTRODUCTION TO ISLAMIC FINANCE
Shari'ah scholars more familiar with the new market situation but
also through their exercise of istinbat contributes to the evolution of
Islamic jurisprudence. Thus, if a practice is held to be un-Islamic by
the Shari'ah scholars a suitable alternative is also sought by the joint
efforts of the Shari'ah scholars and the management of the Islamic
banks. The resolutions of the Shari'ah Boards have by now
produced dozens of volumes — a contribution which can never be
under-rated.
Another major contribution of the Islamic banks is that they
have now asserted themselves in the international market, and
Islamic banking as distinguished from conventional banking is
being gradually recognized throughout the world. This is how I
explain my comment that they have contributed a lot. On the other
hand there are a number of deficiencies in the working of the
present Islamic banks which should be analyzed with all seriousness.
First of all, the concept of Islamic banking was based on an
economic philosophy underlying the rules and principles of
Shari'ah. In the context of interest-free banking this philosophy
aimed at establishing distributive justice free from all sorts of
exploitation. As I have explained in a number of articles, the
instrument of interest has a constant tendency in favor of the rich
and against the interests of the common people. The rich
industrialists by borrowing huge amounts from the bank utilize the
money of the depositors in their huge profitable projects. After they
earn profits, they do not let the depositors share these profits except
to the extent of a meager rate of interest and this is also taken by
them by adding it to the cost of their products. Therefore, looked at
from macro level, they pay nothing to the depositors. While in the
extreme cases of losses which lead to their bankruptcy and the
consequent bankruptcy of the bank itself, the whole loss is suffered
by the depositors. This is how interest creates inequity and
imbalance in the distribution of wealth.
Contrary to this is the case of Islamic financing. The ideal
instrument of financing according to Shari'ah is musharakah where
the profits and losses both are shared by both the parties according
to equitable proportion. Musharakah provides better opportunities
for the depositors to share actual profits earned by the business
which in normal cases may be much higher than the rate of interest.
Since the profits cannot be determined unless the relevant
164
THE PERFORMANCE OF THE ISLAMIC BANKS - A REALISTIC EVALUATION
commodities are completely sold, the profits paid to the depositors
cannot be added to the cost of production, therefore, unlike the
interest-based system the amount paid to the depositors cannot be
claimed back through increase in the prices.
This philosophy cannot be translated into reality unless the use
of the musharakah is expanded by the Islamic banks. It is true that
there are practical problems in using the musharakah as a mode of
financing especially in the present atmosphere where the Islamic
banks are working in isolation and, mostly without the support of
their respective governments. The fact, however, remains that the
Islamic banks should have gressed towards musharakah in gradual
phases and should have increased the size of musharakah financing.
Unfortunately, the Islamic banks have overlooked this basic
requirement of Islamic banking and there are no visible efforts to
progress towards this transaction even in a gradual manner even on
a selective basis. This situation has resulted in a number of adverse
factors :
Firstly, the basic philosophy of Islamic banking seems to be
totally neglected.
Secondly, by ignoring the instrument of musharakah the Islamic
banks are forced to use the instrument of murabahah and ijarah and
these too, within the framework of the conventional benchmarks
like Libber etc. where the net result is not materially different from
the interest based transactions. I do not subscribe to the view of
those people who do not find any difference between the
transactions of conventional banks and murabahah and ijarah and
who blame the instruments of murabahah and ijarah for
perpetuating the same business with a different name, because if
murabahah and ijarah are implemented with their necessary
conditions, they have many points of difference which distinguish
them from interest-based transactions. However, one cannot deny
that these two transactions are not originally modes of financing in
Shari'ah. The Shari'ah scholars have allowed their use for financing
purposes only in those spheres where musharakah cannot work and
that too with certain conditions. This allowance should not be
taken as a permanent rule for all sorts of transactions and the entire
operations of Islamic Banks should not revolve around it.
Thirdly, when people realize that income from in the
transactions undertaken by Islamic banks is dubious akin to the
165
AN INTRODUCTION TO ISLAMIC FINANCE
transactions of conventional banks, they become skeptical towards
the functioning of Islamic banks.
Fourthly, if all the transactions of Islamic banks are based on the
above devices it becomes very difficult to argue for the case of
Islamic banking before the masses especially, before the non-
Muslims who feel that it is nothing but a matter of twisting of
documents only.
It is observed in a number of Islamic banks that even
murabahah and ijarah are not effected according to the procedure
required by the Shari'ah. The basic concept of murabahah was that
the bank should purchase the commodity and then sell it to the
customer on deferred payment basis at a margin of profit. From the
Shari'ah point of view it is necessary that the commodity should
come into the ownership and at least in the constructive possession
of the bank before it is sold to the customer. The bank should bear
the risk of the commodity during the period it is owned and
possessed by the bank. It is observed that many Islamic banks and
financial institutions commit a number of mistakes with regard to
this transaction:
Some financial institutions have presumed that murabahah is
the substitute for interest, for all practical purposes. Therefore, they
contract a murabahah even when the client wants funds for his
overhead expenses like paying salaries or bills for the goods and
services already consumed. Obviously murabahah cannot be
effected in this case because no commodity is being purchased by
the bank.
In some cases the client purchases the commodity on his own
prior to any agreement with the Islamic Bank and a murabahah is
effected on a buy-back basis. This is again contrary to the Islamic
principles because the buy-back arrangement is unanimously held as
prohibited in Shari'ah.
In some cases the client himself is made an agent for the bank to
purchase a commodity and to sell it to himself immediately after
acquiring the commodity. This is not in accordance with the basic
conditions of the permissibility of murabahah. If the client himself
is made an agent to purchase the commodity, his capacity as an
agent must be distinguished from his capacity as a buyer which
means that after purchasing commodity on behalf of the bank he
must inform the bank that he has effected the purchase on its behalf
166
THE PERFORMANCE OF THE ISLAMIC BANKS - A REALISTIC EVALUATION
and then the commodity should be sold to him by the bank
through a proper offer and acceptance which may be effected
through the exchange of telexes or faxes.
As explained earlier murabahah is a kind of sale and it is an
established principle of Shari'ah that the price must be determined
at the time of sale. This price can neither be increased nor reduced
unilaterally once it is fixed by the parties. It is observed that some
financial institutions increase the price of murabahah in the case of
late payment which is not allowed in Shari'ah. Some financial
institutions roll-over the murabahah in the case of default by the
client. Obviously, this practice is not warranted by Shari'ah because
once the commodity is sold to the customer it cannot be the subject
matter of another sale to the same customer.
In transactions of ijarah also some requirements of Shari'ah are
often overlooked. It is a prerequisite for a valid ijarah that the lessor
bears the risks related to the ownership of the leased asset and that
the usufruct of the leased asset must be made available to the lessee
for which he pays rent. It is observed in a number of ijarah
agreements that these rules are violated. Even in the case of
destruction of the asset due to force majeure, the lessee is required
to keep paying the rent which means that the lessor neither assumes
the liability for his ownership nor offers any usufruct to the lessee.
This type of ijarah is against the basic principles of Shari'ah.
The Islamic banking is based on principles different from those
followed in conventional banking system. It is therefore logical that
the results of their operations are not necessarily the same in terms
of profitability. An Islamic bank may earn more in some cases and
may earn less in some others. If our target is always to match the
conventional banks in terms of profits, we can hardly develop our
own products based on pure Islamic principles. Unless the sponsors
of the bank as well as its management and its clientele realize this
fact and are ready to accept different - but not necessarily adverse -
results, the Islamic banks will keep using artificial devices and a true
Islamic system will not come into being.
According to the Islamic principles, business transactions can
never be separated from the moral objectives of the society.
Therefore, Islamic banks were supposed to adopt new financing
policies and to explore new channels of investments which may
encourage development and support the small scale traders to lift up
167
AN INTRODUCTION TO ISLAMIC FINANCE
their economic level. A very few Islamic banks and financial
institutions have paid attention to this aspect. Unlike the
conventional financial institutions who strive for nothing but
making enormous profits, the Islamic banks should have taken the
fulfillment of the needs of the society as one of their major
objectives and should have given preference to the products which
may help the common people to raise their standard of living. They
should have invented new schemes for house-financing, vehicle-
financing and rehabilitation-financing for the small traders. This
area still awaits attention of the Islamic banks.
The case of Islamic banking cannot be advanced unless a strong
system of inter-bank transactions based on Islamic principles is
developed. The lack of such a system forces the Islamic banks to
turn to the conventional banks for their short term needs of
liquidity which the conventional banks do not provide without
either an open or camouflaged interest. The creation of an inter-
bank relationship based on Islamic principles should no longer be
deemed difficult. The number of Islamic financial institutions today
has reached around two hundred. They can create a fund with a
mixture of murabahah and ijarah instruments the units of which
can be used even for overnight transactions. If they develop such a
fund it may solve a number of problems.
Lastly, the Islamic banks should develop their own culture.
Obviously, Islam is not restricted to the banking transactions. It is a
set of rules and principles governing the whole human life.
Therefore, for being 'Islamic' it is not sufficient to design the
transactions on Islamic principles. It is also necessary that the
outlook of the institution and its staff reflects the Islamic identity
quite distinguished from the conventional institution. This requires
a major change in the general attitude of the institution and its
management. Islamic obligations of worship as well as the ethical
norms must be prominent in the whole atmosphere of an
institution which claims to be Islamic. This is an area in which
some Islamic institutions in the Middle East have made progress.
However, it should be a distinguishing feature of all the Islamic
banks and financial institutions throughout the world. The
guidance of Shari'ah Boards should be sought in this area also.
The purpose of this discussion, as clarified at the outset, is by no
means to discourage the Islamic Banks or to find faults with them.
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THE PERFORMANCE OF THE ISLAMIC BANKS - A REALISTIC EVALUATION
The only purpose is to persuade them to evaluate their own
performance from the Shari'ah point of view and to adopt a realistic
approach while designing their procedure and determining their
policies.
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